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Options Income Strategies May Be Dangerous To Your Health

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Tue, Dec 21, 2010

This blog post is an excerpt from the Essential Lessons of Investing Series

Lesson 15 Why Options Income Strategies are Dangerous to Your Financial Health

Whoever named these derivative instruments “options” had a cruel sense of humor.  They feel 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 income selling 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 to your financial health. For traders and swing to intermediate-term trading system developers with a competitive model, it’s actually far better to be an option buyer than an option seller. This blog post will attempt to explain why.

A little personal background
When I was much younger, I returned from Paris to co-manage an emerging markets bond portfolio with a hedge fund in New York and learned many lessons simply by keeping my eyes and 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 annual returns. One of the things that struck me most was that the hedge fund completely avoided options 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 some fresh blood in order to get up to speed on the greeks. But over the years, I began to realize why the New York hedge fund that I worked for many moons ago firmly decided to avoid complex options strategies. The Paris-based hedge fund that I worked for also cut back on options income trading because those accounts were going nowhere. The head options trader at the Paris hedge fund sat just across from me – he was well-educated and had superior quantitative-analytical skills. 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 were essentially going nowhere, he was asked to stop. In all my years in the industry, I have yet to meet someone who has consistently made money with option income strategies over a prolonged period 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 treacherous road of options income trading!” I realized that I simply had to get the word out about how dangerous options income trading is.

What exactly are option income or option selling strategies? Briefly said, option income strategies are designed to take advantage of the time decay of options by collecting (and hopefully keeping) the premium sold. Theta is the options greek that has to do with the decay of time 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 that 70% of all options contracts expire worthless. So everyone should be an options seller (or writer), right?

We’d all be pretty stinking rich if this were the case. In practice, there’s tremendous skill, experience, capital and psychological fortitude required to manage the risk of an options selling strategy. In addition, what many of those sleek options mentoring courses don’t tell you is that there’s a huge difference between the probability of keeping premium at expiration, versus the probably 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 a call (put) and selling another call (put) simultaneously for a net debit (taking in less premium than paying out).

What all these income options strategies have in common (probably best seen graphically), is that they all try to build some sort of a roof-top over the underlying price movement in an effort to 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). This lop-sided potential for losses at the wings is typical of option income strategies and is what makes them so dangerous. As an example, the iron condor (as shown below) is designed to profit from prices staying inside the price range of the two short strikes (the short 118 put and the short 130 call). In this example, the 118-130 range is the roof-top that is typical of options income strategies.

These strikes were selected based on the 68% probability range at expiration. Doesn’t the iron condor strategy vaguely remind you of the normal distribution bell curve? It should. High probability trades 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 traders overlook this to mean that there’s a 68% probability that the price action will not penetrate the 118-130 (short strikes) range during the life of these 1 month options. However, the probability that prices will not penetrate the roof-top range during the life of the options is actually 31%, not 68%! There is a big difference between where prices will be at expiration vs. during the life of the option. If you factor in the probability of penetrating the inside strikes during the life of the options, together with slippage and commissions, you end up with a negative expected return! Using the expected return formula: % Winning trades x Avg Win + % Losing trades x Avg Loss, for the typical iron condor we have 31% x 6.7% + 69% x (-13%) = -6.89%, and this is before slippage and the cost of adjustments! Many inexperienced options come to the option income strategy waterhole because they expect a high probability (limited profit) trade – consistent, couch-potato income, remember? – but in fact they’re getting low probability limited income 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 message is 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 mathematical certainty of time decaydon’t most options expire worthless? Yes, but virtually every options trader 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 insurance carriers out there competing for policies, term life insurance underwriters are most likely assuming greater risk than they should – because the premiums are so ridiculously low. The same holds 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 aren’t getting paid enough for the risk they assume, then option buyers are getting a bargain more often than not. Another reason is that the 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 so the 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 things simple: follow the trend and let your profits run using longer-dated in-the-money long calls or long puts.

There are some highly experienced option income traders who are masterful at adjusting their iron condors, butterflies, calendars, etc. before and when prices fall off the deep end. But these folks are extremely rare. Chances are, these are ex-option-market-makers with a keen understanding of the greeks – particularly, of delta and gamma hedging. Yet all the options adjustment skills in the world can’t address the issue of violent overnight gaps, for example. Gaps make price action containment (as all option income strategies try to do) virtually unfeasible. For most of us directional folks trading through a broker, it’s better to work at honing your 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 (especially those with multiple legs), should be avoided:

1. Options are illiquid instruments. As derivative instruments, the total equity options market in terms of volume traded in the U.S. (as measured by the Options Industry Council) represents less than half of 1% of the total volume for the Russell 3000 (R3K represents 98% of the invest-able universe of stocks). (This figure makes you chuckle when you hear market sentiment analysts poring over put/call ratios when you consider just how small the options market is as a percentage of the entire stock market). Liquidity basically refers to how easy it is to enter or exit positions – in terms of not having to pay for

a)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 options because sizable orders will literally push prices in the direction of the order – resulting in terrible fill prices

c)Options exchange margin requirements – that is, how much cash you have to maintain in the account to cover options positions that you wrote (or sold). These can freeze you into holding positions 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 to get out by selling the “painful” leg of an options spread trade – but you can’t! You have to get out your surgical gloves and piece by piece unwind the legs of the position. This can be a nightmare 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 bull put or bear call), that will cost you $100. If the market goes against you directionally, you’ll have to pay another $100 to unwind the position. That’s 2% of a $10,000 options account just for entry and exit costs.

Oh, and let’s not forget about the slippage for the illiquidity points made above. That’ll cost you another 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 options decays exponentially the closer you get to expiration – unless implied volatility (the risk of the underlying 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) should consider 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 concept indeed.

Long option strategies do have one important thing going for them:  they cap downside risk.  But this 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 includes not only the premium but also the slippage and commission. So if your directional skills are not exceptional (greater than 55%), long option strategies can also turn into a losing proposition.

4. Options are leveraged instruments and the leverage factor is not constant. This means that unless you’re super careful,being mindful of the greeks (particularly gamma and delta), your position can explode in your face. This is particularly true for options selling strategies when the underlying market has moved a great deal.

As mentioned earlier, the issue of probability of touching vs. probability at expiration is prevalent with all option selling strategies.  Whenever you create a roof over the price action (as can be clearly seen in the case of the iron condor discussed earlier), you’re essentially trying to contain the price movement in some way in order to keep the net premium sold.  Covered calls are also option selling strategies (long stock plus short call=short put), that try to contain the price action above a certain pain threshold.  Covered calls are a popular way to generate income but present unlimited downside risk in bear markets.  Needless to say, option selling strategies that try to contain the direction of the market in some way are extremely dangerous in view of truly unexpected market volatility like we had during the Flash Crash of May 6, 2010 when Dow Jones Industrial Average gyrated by more than a 1000 point swing on an intra-day basis. Or how about when the market gaps up or down in a big way? Good luck trying to “contain” the price action under these circulstances!

It makes no sense to me to put on complex, cumbersome, and expensive options strategies that generate limited % yield (or income) and either do not work most of the time or leave you exposed to significant downside risk!

Despite all the hype about 70% of all options expiring worthless at expiration, as we’ve seen, what really matters is the risk that you assume during the life of the options strategy.  The options brokerage firms should really be advertising that you have less than a 50% chance of keeping the premium whenever you sell options – and that is before factoring in the exorbitant slippage and commission costs.  Blackjack at the casinos offer 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.  Options brokerage firms lure you in with state of the art trading execution and analytical platforms – with all the greeks (delta, gamma, theta, vega), pay-off simulations, probability analysis, implied volatility – all in real time with split-second execution.

There are literally thousands of variations or views you can have by combining multiple legs with even or uneven weightings, across a wide range of strikes and expiration months.  Options traders are not two-dimensional – heaven forbid, that’s for brutes – typically they are three dimensional – incorporating not only price and time but also volatility into their views.   In this sense, 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 especially with leveraged derivative instruments can easily become the kiss of death.

Many options traders won’t admit to this, but I feel that one of the chief reasons people trade options (instead of the traditional, two-dimensional boring stocks and ETFs, or i-t-m calls/puts e.g.), is that they simply can’t take losing trades.  There are many options mentoring sites out there whose key selling point is “never having to take a losing trade,” or “how to turn a losing trade into a winning trade.”  The magic word here is adjustment.  “We’ll show you how to adjust your options positions so you almost never have to take a loss.”  What they forget to tell you is that there’s an opportunity cost of trying to salvage losing trades.  Sure, you can restructure your losing iron condor or calendar trade in an attempt to get back to break-even – but doing so will take at least another three weeks.  You’ve simply tied up your capital that could have been used more productively on another potentially profitable trade idea.  And, once again, after you factor in 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), you’re lucky to get back to break-even at best.

Options trading opens a Pandora’s box of temptations.  By presenting thousands of variations and strategies 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 leads to more slippage and commissions. 

In sum, when it comes to options income trading, the odds are stacked against you.  When you factor in the lack of liquidity, the potential of being frozen into losing positions due to margin requirements, exorbitant cost of slippage and commissions, the opportunity cost of adjusting losing trades, not to mention the the huge temptation of trying new and  aggressive ideas – it behooves 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 by avoiding complex options income strategies.  If you really must try out these strategies, I recommend that you trade real money (paper trading is useless because it does not factor in all real-world challenges, variables and emotional considerations), but that you trade extremely small size. Prove that you can turn a $5,000 account into at least double that in 3 years using options.  If you can’t, then you shouldn’t be trading options for income at all. You would be better off focusing on honing your directional modeling or subscribing to a solid market timing methodology combined with  sensible risk management for a portfolio of ETFs, stocks or in-the-money long option strategies. These should do nicely instead – and you’ll have a lot less headaches.

Disclosure: I am long IWS, IWM.