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Stuart Hazlewood wrote:
>The real news is that, according to Anand, this range has held true
>historically 90% of the time. He therefore recommends strategies that
>are short at 1 sigma based on the at the money IV.
My comments basically address the strategy of holding short option positions
to expiration. I realize that Stuart is considering more sophisticated
strategies with adjustments along the way. My main concern is the danger of
trading based on statistical results at expiration, without understanding what
a nervous ride it can be. The psychology is different when you're betting that
an unlikely event won't happen.
Richard correctly pointed out that maximum price excursion before expiration
is more important than price at expiration. The method may be profitable, and
the 90% figure may be accurate, but can the trader survive the experience?
Imagine being short for 30 days in a trade that goes well until expiration
week, when it reverses and threatens to become unprofitable, and is right
on the line with 1 hour left to trade. This will happen. How will you feel
if you hold and it fails right at the end? How will you feel if you exit
to be safe, and it would have worked out OK? (30 days down the drain)
The 30 day statistical trade can turn into a one-hour crapshoot.
Some of your 90% winners will be easy, when the market never approaches
the danger zone, and premium erodes steadily. You will sometimes be able
to close at 1/16 or 1/8 long before expiration. Other times, the index
will be close enough to the danger zone that premium will not erode
until the bitter end in the last days or hours. As time runs out,
a sudden move against you becomes more and more expensive.
A successful trade on the long side carries with it a sense of relief
because if your option goes from 2 to 3 right away, you can normally
make sure it won't be a loser. When you're short with the intention of
waiting until expiration, initial success means nothing.
Psychologically, for the entire length of the trade, you're hoping that
something will not happen, but you know it will happen 10% of the time.
The S&P usually does not explode upward, but it possibly might, and
you have to live with that fear. You could short a naked call at 2,
watch it rise to 10 before the index threatens your limit, and then
watch it open the next day at 20. (You don't cover at 10 because the
market is still within normal parameters. Without some bail-out point
you don't even cover at 20, or 50, or 100. If you DO have a bail-out
point somewhere, it is based on price excursion before expiration
and therefore you cannot expect 90% success, since 90% is based on
holding to expiration no matter what.)
The guy on the other side of your trade has a maximum risk of $200 and
unlimited upside potential. When the call is at 10, his fear is losing
some of his profit, or missing out on further gains. Your fear is
unlimited loss and ruin. Who will be more prone to error, and which
decision has greater consequence?
Wayne Moody
wlm95@xxxxxxxxxx
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