Thursday, July 29, 2010

Taking advantage of Time Decay in Options

Krishna has this point to make:
"Why one should not write stardles or strangles to take advantage of time decay.


I have seen that it normally decays and can fetch a decent money if written in the beginning of series.


Is really risk is so high that retail traders should never go for it ??


Normally retail traders keep burning their hands through buying options as it gives a fake feeling of limited loss.Truth is very few retail traders make money in buying options while on the other hands options writers take good advantage of time decay through writing.


Please note that I am not talking about naked CALL or PUT writing but starddle or strangle seem reasonably good tool to make money.


I have studied on above matter through paper trading for almost one year and in my knowledge area results are normally okay"
 
My Notes:
A straddle is a combined unit of call and put of the same strike price. buying a straddle refers to the purchase of same strike call and put. Selling a straddle refers to the sale of same strike call and put.
 
The Straddle buyer and seller take opposite sides of the same transaction. Therefore, only one of them makes money. Which one? Let us take August series:
5400 Call: Rs 105
5400 Put: Rs 91
 
If we wish to sell a straddle, we receive Rs 196. Our breakeven is 5596 and 5204. Suppose a correction takes the Nifty down to 5200 in the next 10 days, say around August 7. What should the seller do? There is a chance that the Nifty may rally back to 5400 by the end of the series, i.e. by August 26. Should he wait?  Suppose the correction deepens and the Nifty closes at 5000 by the end of August. Then, the writer loses almost 200 points.
 
The problem with writing straddles is the confusion on the follow up action required, if market suddenly moves in one direction much before options expiry.
 
If you were a straddle buyer, and the Nifty fell to 5200, you could close out your straddle for maybe 240, thus making 40 points on an investment of 196. Or, you could sell an at the money put of 5200 strike for maybe 50 and also sell the 5400 call for 20, thus having a put spread 5400 to 5200 for a cost of 126 and potential gain of 74 points. Or you could simply sell the 5400 call for 20 if you were now looking for a deep correction. With a long straddle, there are many opportunities for adjustments.
 
The difference is risk. Short straddles have unlimited risk. Now, the risk can be managed, but once in a while it becomes unmanageable - browse the web on Long term capital management, Victor Niederhoffer, for just two of the big blowups selling options.
 
Buying a straddle limits your risk. If option premiums are high, you have a choice, do not buy options at all.
 
 

5 comments:

vaibhav said...

hello sir -- the point raised by krishna is very valid indeed -- i prefer to sell out of the money STRANGLES -- instead of straddle-- say sell aug 5600 CE @ 70 + as welll as 5200 PE @ say 50 + == a total 120 points upfront cash flow into the account-- wide range of safety -- 5080--5720-- and also protect the losing position -- like -- if nifty drops to 5300 -- then again can sell 5400/5500 calls to protect short 5200 PE -- IF DONE WITHPROPER MONEY MANAGEMENT AS WELL AS POSITION SIZING --this is one of the best strategies in RANGEBOUND MARKETS --RESPECTED SUKHANI JI -- your valued and expert opinion is requested -- dr vaibhav

bkm said...

Sir,
It really was an frustrating experience from July 7th till expiry, barring a period from nifty's travel above 5400 to 5460 and back to 5400. The range was 5360 to 5410 rest of the time.

In last 3 years I have not seen such a close move of nifty like this, with your experience you may provide more light on trading during such a time.

Also sir, I would like to have your suggestion what should be done on an expiry day like today, the period between 2.53 p.m. to 3.01 p.m. the nifty along with many puts and calls went nastily from one direction to other, while nifty came swiftly from 5408 to 5390 and then back to 5408 .

bkm

akn said...

In my personal experience, Covered Puts (or Covered Calls) are better when markets are range bound. For eg. Write 5200 Puts and Short 5400 Futures. Also hedges your long-only portfolio. The premium received can be used towards stop-loss for the futures. A 200 pt gap works well for me.

Nikhil said...

Thank you sir.

anibhai said...

hello sir
nifty seems to have broken down from a rissing bearish wedge with negative oscillators on the daily chart
i think this is a good place to take a long term short position with a SL above the highs, the risk is 100 points to the upside and reward is atleast 500 pts over time
check this chart
http://stockcharts.com/h-sc/ui?s=$BSE&p=D&yr=1&mn=0&dy=0&id=p69901023178&a=182867862&listNum=6&listNum=6