Monday, April 28, 2008

White Swan Trading

A much simpler to understand study about the profitability of selling put options. I've sold options in the past - several years ago - and am thinking of doing so again in a small way. Selling a put credit spread - selling a put option and buying a more out of the money put - is safer as you buy insurance against a market crash while selling insurance against a small market dip. This reduces returns and increases the probability of losing money but eliminates the possibility of losing big. I'm thinking of entering these transactions in stages using my model to find optimal points to sell and buy. I'll sell some puts in order to acquire stocks and also sell index puts.

I was very interested in the iron condor strategy, but after research over the weekend it looks a lot less attractive. The iron condor involves selling a put credit spread as described above and also selling a call credit spread. A call credit spread means you sell a call option and buy one further out of the money in order to insure against a runaway market rally. (Selling a call option means giving someone the right to buy the stock from you - if you don't own the stock you need to go into the market and buy it at the current price. This is costly if the market rises a lot. From an economic perspective it actually doesn't matter whether you own the stock already or not as selling a stock at less than the market price to someone has an opportunity cost).

The interesting thing about the iron condor (I am assuming that both the sold put and call are at the same strike price) is that the maximum amount you can lose is less than the maximum you can lose from the put spread and the maximum profit is higher than the maximum profit from the put spread. This sounds like a "free lunch", which economics tells us does not exist :) The reason is that you keep the credit from both options transactions but only one of the sold options can end up in the money at expiry. With the put spread you only have one credit and so when you lose you lose bigger and when you win you win smaller. But, alas, there is no free lunch. The probability of a loss is now more than doubled! And the probability of getting the maximum profit has declined from more than 50% to near zero. In the case of the put spread you only lose if the market goes down. But with the iron condor you might lose if the market goes up or down. And in the long run the stock market tends to go up. Therefore, the probability of loss is more than doubled. And, in the case of the put spread as long as the market is above the sold put strike at expiry you make the maximum profit. Which happens more than 50% of the time (if you enter the market randomly). But in the case of the Iron Condor, you only get the maximum profit if the market is exactly at the strike price at expiry, which has a low probability.

The Iron Condor looks like a win-win to the naive observer, but deeper analysis shows that selling put spreads and naked puts has a higher expected return.

There is an interesting reference at the end of the article to Nassim Taleb's black swan strategy, which involves buying out of the money puts and suffering through many small losses in the hope of scoring the occasional big win on a market collapse. It's interesting that Taleb doesn't provide any evidence of his strategy's returns. The academic evidence on put selling involves selling near or at the money puts. Perhaps a buying strategy works if the puts involved are sufficiently out of the money? Michael Statsny argues that the black swan strategy doesn't work. By contrast, the white swan strategy involves collecting regular profits and occasionally taking a big hit. Famously, Victor Niederhoffer blew up from put selling. This can be avoided by not using too much leverage. You should never sell more puts than you'd be willing to buy stocks even if margin requirements allow you to. The same goes for futures trading and options buying.

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