I attended one of the Options Industry Council's advanced seminars here in the SF Bay Area last night. I wanted to see how they presented options strategies and needed some refresher education on spreads. I don't need to rehash the structures of condors and butterflies here. Think of this as an "inside baseball" look into aspects of the financial sector that sometimes escape public notice.
The audience was sufficiently mixed to reflect the Bay Area's diversity. Every ethnicity was present among the 100 or so attendees but they were overwhelmingly male and older (mid-50s and up). I noticed that almost everyone in attendance wore a pressed collared shirt, including me. This one wardrobe choice contrasted markedly with a particular real estate seminar I once attended, where everyone dressed like a slob. These folks also asked intelligent questions. It was obvious that this OIC crowd was upscale, educated, and successful based on their sartorial details and knowledge. These were serious makers, not ignorant takers. Quite a few had attended these seminars before. I had to miss the session on "Greeks" the previous day but a lot of these folks were there and their questions reflected what they learned.
The instructor was a trading floor pro with a background on the major exchanges. He mentioned the Silicon Valley Options Group as a source of wisdom for traders, so that's one more thing I need to go experience on my very long list. One funny guy in this class quipped about a trading strategy we wouldn't learn today - the "albatross." Unlike the condor and butterfly, it's the one that doesn't fly. Har-de-har-har. Investors can use that line for every trade that doesn't work out.
Option types are proliferating because IMHO financial innovators need things to invent after they get bored with hedge fund algos. Guess what . . . mini-options are now available representing 10-share lots. I haven't seen them in my online brokerage's execution page so maybe you need a specialist to trade them. I think that's one way for smaller investors to write covered calls on stocks with three-digit prices without overconcentrating them in a portfolio. Other special options on stock splits, reverse splits, and other corporate actions have been around for a while. Those can look cheap but have huge exposure. I found out the hard way some years ago on that score. It was cool to learn that weekly options now have 20% of all option volume.
Here's something about options brokers I never learned when I worked in a large retail brokerage myself. A live broker always executes the buy leg of a spread first, then the sell leg. Why anyone would call a live broker today when online brokerage orders offer instant execution is beyond me, but some old-school technophobe fogies must need it.
The market for reverse conversion strategies helps keep calls and puts generally in parity through options arbitrage. I've known about put-call parity since long before I wrote a special report on what it can indicate about the state of the market.
Pin risk occurs when a security closes very near the strike price of an option at expiration. This forces an option to be assigned when the counterparty orders it executed. It usually aligns with a huge open interest option position because the supply and demand for a security at that price will make it "pin" to the strike price of that open position. It's really a risk factor caused by stock investors hedging their positions close to expiration. Large investors who "pound" a stock near expiration may have covered calls and don't want the position called away. This can be costly and I wonder if large investors think about whether the cost of opening long puts or shorting the stock is worth preserving an unrealized gain.
I was surprised to learn that most option traders don't hold butterflies to expiration but close them out. I'd like to find research confirming that discovery. They also tend to unwind an open spread one leg at a time. These oddities make me wonder if option traders just wing it (huh-huh, pun on condors and butterflies) when they enter a position. I've unwound only a handful of option positions in my life. The vast majority I held to expiration. That's just the way I am. I don't second-guess myself halfway through the execution of a strategy in which I have confidence.
Expected volatility has a big influence on whether spreads are profitable. I personally do not forecast the movements of stock prices or other things because the future is unknowable and many forecasting methods in finance are little more than voodoo. Some of the investors here revealed that they use technical chart patterns as stock forecasting tools to select their option strategies. Oh boy, that's just great. I consider that to be an amateurish and faux-sophisticated way to approach investing.
There are some ways that an open short call can be assigned to an option writer before expiration, like when it's in-the-money just before the ex-dividend date and the declared dividend will be greater than the short call's time value. Market makers are the decision-makers on early assignment. Pros seek out big open call positions close to the ex-date because they want to assign that call and collect dividends, which is often called "trading dividends." I traded dividends myself (without options) when I was a beginning investor but it's a habit I outgrew when I discovered fundamental methods of analysis. It's also worth noting that the risk of early assignment is only present for stocks and ETFs that pay dividends, so a no-dividend policy obviates this risk.
Did you ever wonder why some spreads are called condors and butterflies? I never did but the instructor told us anyway. A real live butterfly is narrower than a condor, measured by wingspan relative to the body. The analogy to options is that a condor spread is wider because it stretches across four strike prices instead of a butterfly's three. 'Betcha didn't know that. I didn't care all that much but maybe someone out there does care.
Condors work best when there's lots of liquidity in an options chain with narrow spreads. The iron butterfly can have higher margin costs than its condor counterpart. These insights beg the question of why anyone would choose a butterfly over a condor. Beats me. The iron butterfly gives me the impression that risk-seeking investors would prefer it over the iron condor. The thing about condors that deters me from using them is the chance of a "blowout trade" happening when an investor is tempted to keep shorting the condor's wings while the stock price keeps dropping. Ah, no thanks.
My own preferred option strategies are covered calls, cash-covered puts, short straddles, or simple directional bets for speculation (like my recent bet against the euro). I don't need NASDAQ Level 2 quotes and I don't need to see the up-to-the-nanosecond national best bid and offer (NBBO) to decide to execute any options strategies. I suspect that many options strategies are like the technical indicators that drive some forecasting, in that they exist only because market makers and analysts want them to exist. It's a way to create a body of knowledge just to make pros look knowledgeable to outsiders. There need to be more academic studies on things like the ROI of condors and butterflies to determine whether they truly add value to a portfolio. The audit trails inside the longest-lived hedge funds probably have enough data for many such studies. Civilization needs serious studies because I'm just not convinced that more complex strategies add more value to a portfolio than simple hedges.
None of the sample strategies the seminar examined had any losing trades. Of course not! Real trades do lose money from time to time. Mine certainly have. I've done enough options trades over the years that the winning trades more than make up for the losers and my net worth has grown as a result. The sting of a losing trade creates a long and indelible memory for a serious investor. I've learned from each of my losses. Read about a few of them in my older blog articles.
One final episode amused me. One guy standing near the soft drink table in back said he thought the ongoing financial crisis in Cyprus wouldn't hurt the U.S. economy. So many people are oblivious, even among serious investors! He truly believed that Americans would keep buying housing no matter what happened on that Mediterranean island. I wasn't inclined to run through the dominoes of Cypriot bank insolvencies, a forced euro exit, Continental bank runs, more PIIGS euro exits, activated Fed-to-ECB swap lines that risk a run on the dollar, and all of the other grey swans my regular readers have seen me write about for years. I just shook my head and grabbed a soda. That was the only option I needed last night. There will be many chances in the near future to execute other options.
