Friday, March 03, 2006

Buy Premium! (Part I)

Unsurprisingly slow Friday. I don't have much to report as far as our fund's activities are concerned and I'll use this opportunity to share an educational post. Below is the first part of the article:

As some of my readers know one of the key strategies at Cadence Capital is premium selling. I love the strategy for many reasons but one of the drawbacks that always leaves a bitter taste in my mouth (even after making money) is its capped return. Granted, you can be the best options seller but 5% a month on your capital is probably the best you can hope for - with any sort of consistency. By the way, before I get bombarded with "I can do 15% a month, no problem" type of emails, keep in mind that this 5% is calculated on your entire account capital, not a particular monster trade that you did that month.

So, how does one position for a higher return? The only answer I have is "buy premium". I realize it may be funny that a net seller is recommending to buy options but there is really nothing strange about this: you have to diversify across strategies (read my earlier post on this topic) if you want consistent returns with a high Sharpe ratio (volatility of P&L your client can stomach)

Naturally, being long options can be for two basic reasons (aside from more exotic ones):
  1. You have a volatility view
  2. You have a directional view
I like to buy premium for either reason but ultimately, it's best to do it for both.

If you're going long vol you'll buy options and stock (assuming puts) and scalp gamma in either direction. Your bet here is that realized volatility of the underlying will outpace theta of the options. You'll make money if the underlying moves up and down in a proximity of the strike. You'll make money if the underlying moves strongly in one direction (here you'll have to exercise staying power to not "cover" too early).

This strategy (by the way, this is often called a "synthetic strangle") works well with implied vol being on the downside and technical positioning of the underlying spelling a high probability of movement. Recently, Oil stocks served as excellent examples for this sort of play.

If you going long direction then you'll buy options the way you'd normally buy stock. Naturally you'll still have to pay attention to implied volatility (you don't want vol crush to decimate your profits even when you get the direction right). However, there are several other key considerations that need to be taken into account (and they are the ones that make long options so much better than stock) before initiating a long premium position. Yes, leverage is one of them, but it is by far the least significant one on my list. We'll cover the art of buying premium in detail in Part II of this article.



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