As of recent, I’ve been reading up pretty heavily on options strategies. That being said, I think I should take a minute to clarify what I mean by that. I’m not going out to options-trading-mastery.info (not a real site), trying to learn some sort of hidden-guru-secret that will make me rich over-night. I’m instead completing my derivatives trading license as a professional banker.
Having gone through the professional books, I can tell you now, there are some pretty interesting differences between the practicalities of options, and the ‘guru-secrets’ that some of the crazy people online will try and sell you on. Specifically, there seems to be a fascination with linear risk and reward in the online space, while the exam I’m taking focuses in more on the mathematical derivatives (commonly referred to as ‘the Greeks’) associated with derivatives.
While I don’t want to bore you with the details of how a call option is intrinsically related to interest rates by less than a percentage point, I do want to take a moment to demonstrate a specific strategy that I read about online, and how it is that it can possibly be misrepresented or interpreted by the unwary reader. This week, I’m going to show you how to stumble into a lousy options position in less than a week, based on the advice presented by an ‘options advice’ website that doesn’t quite have as much concern about your financial wellness as we do here at PFhub.
The first red-flag I saw about this position when it was described was its title. An “Options Strangle” is a position that involves three kinds of holdings. The first step to entering this kind of position is purchase a long position in increments of 100 units at a time, so that it can be fully hedged through options contracts. The next step involves introducing a ‘strangle’ position by selling both a put and a call on the position at the same time.
The end result is a position that is held to collect dividends, a put that is sold to create inflows, and reduces the dollar-cost-average (the on-paper amount that you paid for the position) of the position, while still presenting an opportunity to increase exposure to the stock if it should experience a short-term decrease in price.
Additionally, we have a call position that is sold to further decrease our dollar-cost averaged purchase price, while further providing security against the risk that the position should decrease in value, as well as a cost-effective exit-strategy for the position. Sounds pretty good right? On paper, this is a fantastic position. Here’s a list of all the fantastic benefits we get from this position:
- The immediate effect of a strangle is that our on-paper purchase price of the position has been decreased, resulting in an immediate cash inflow and profit.
- Because our on-paper Dollar-Cost Average is now reduced by the sale of the options contracts, we have a massive (up to 20% in some instances) price cushion. If the price of the security begins to decrease, we have a much larger margin of safety.
- If the price of the position doesn’t see a material change over the period of our options contracts (anywhere from a week to a year), the contracts expire, and we can sell the contracts again, further generating cash profits.
- If the price of the position goes up, and our position gets called away, we aren’t concerned, because our profit cushion made up for approximately double the amount of capital gain that would need to occur to make up for the difference.
Sounds like a sure thing right?
We get immediate profit, we hedge our exposure to capital gains against either direction of volatility, and the position is renewable to the point at which it represents a sustainable source of cash. However, there’s one major flaw to the linear evaluation of this sort of position that creates a serious caveat. Specifically, if you let yourself get caught up in the Options-Guru-Magic that sells the perception of being able to get rich overnight, you can literally lose 100% of the value of your position in less than a week.
In the next post, I’ll show you exactly how it is this happens, and how it is you can modify the position to take into account the missing assumption that breaks the position in practice.
