Comment by k1

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k1
November 8th, 2007 at 5:33 pm
Managing Risk/Reward

Risk/reward and margin

LVS – that spread filled for me at $13.33 for the Dec $125s and $12.68 for selling the Nov $120s. Since the whole trade is .65 if you pay $1 you are overpaying by 50% to enter the trade. Since we should be thilled to make 50% on a spread, it isn’t the kind of thing you should be chasing. You need to keep things in perspective. I’m tying up $2,500 in margin and playing $325 in actual cash. If I make $300 today or tomorrow and can get out, take the money and free up my margin – I should do it! With a $10K portfolio doing that twice a week for a year gets you $30,000 while riding it out means you will get perhaps 18 plays a year with some winners and some losers.

The trick is to get a GOOD deal on a spread and look to get out early. As you increase your portfolio you can make more and more spreads and those 20% gains really start to add up!

Risk/reward and volatility

The question you need to ask yourself is how much do you think you can gain (let’s say 20%) and how much do you think you can lose in this volatility (let’s say 20%). Then you are faced with a choice of, starting with $100 in uncertain times either having $120 or $80 once certainty (to whatever extent) returns vs the guarantee of having $100 which you can place a certain bet on if you stay with cash. If we assume the certain bet down the road returns 20%, then your outcomes are $80-$96, $100-$120, $120-$144. So what you are really faced with is the certainty of having $120 by exercising patience vs the 50% possibility of having just $96 (-20%). While we always want to win, and win more, the reality is that making over 20% 6 periods (going to cash every other time), returns a 198% gain whereas a mix of 12 20% gains and losses yeilds diminishing returns if the 20% gains and losses alternate. Even if your mix was ++-+-+-++–+, which is 7 out of 12 wins, you would end up with just $117.41 at the end of the cycle.

Keeping track of your gains

Whenever I make more than a little on a caller I credit the other end of the spread rather than just dump it to cash as it gives me a quick indicator of where I really am on a position. In that one’s case, it has long since paid for itself and at this point my decisions need to be based on how much profit am I risking vs my expected returns. Looking at it that way makes it much easier for me to let go of big winners (like my Googs the other day) as I could clearly see it made no sense to risk $150 in profits to sell a $18 call to get a 10% premium when I know I can do much better with 10 diversified positions than I can with that single one.

Balance your risk and reward – Emphasis mine

SNDK – the trick is to roll your caller before he gets too far out of the money but this looks like a nice bottom so maybe take him out for .80 and wait for a good time to sell again. Your problem with the Jan $40s is you are TOO FAR IN THE MONEY so your delta is higher than your caller’s. There’s no point to having an option that’s going to lose almost penny for penny with the stock…. Try rolling to 2x Jan $50s at $8.40 and waiting but eventually selling the $55s again for $1.50 but this time you get to sell twice as many against the same leap investment.

Comparison to Lenny Dykstra’s options strategy

I love Lenny but I’ve played craps with him and I don’t know that I would follow his betting strategies! He’s calling for paying a .60 premium to spend (now at $8.40) $8,400 to control 1,000 shares of MSFT through October while I called for spending $600 to control 1,000 shares of MSFT through July (the $30s for .60). So far, his play is down $300 and my play is down $50 but I have $7,800 to spread around on other bets while he (and this IS how he plays craps) has made a huge commitment to a single position.

If MSFT goes to $30 in 2 weeks, his calls will go up to $10.50 (apx), giving him a $1,800 gain while the July $30s would go up to $1.50 (apx) giving us a $900 gain. We could go nuts and put $1,200 down on MSFT and outgain Lenny on a good turn but I’d rather have cash on the side to roll to October if I’m wrong, bracket down or even DD on my position if it quickly goes to .40, which would give me 20 calls at .50 (down 20%) vs a probably $2K loss on Lenny’s position that you would be unlikely to want to double down on.

Dykstra’s strategy is fine for wealthy people or funds dabbling in options as you are taking a 3:1 leverage on positions but buying deep in-the-money positions does little to really enhance your flexiblilty and can be a detriment if the stock moves against you.