Week 38: How to sell vol without risk of ruin
Just because buying options is fun, that doesn't always make it right
Hi. Welcome back to Fifty Trades in Fifty Weeks
This is Week 38
50in50 uses the case study method to go through one real-time trade in detail, about once per week. This Substack is targeted at traders with 0 to 5 years of experience, but I hope that pros will find it valuable too. For a full description of what this is (and who I am), see here.
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Update on previous trades
Week 37: XOM put spread doing well. Note the XOM vs. CL charts were labelled with the wrong colors last week. I fixed them on the Substack. Sorry about that.
Week 36: TGT getting hammered.
Week 35: Short MSTR small in the money, not moving much. I will leave an order to square it up at $160.55 if we get down there.
Week 34: EWZ call spread sucking major wind.
Full update with the detailed spreadsheet in Week 40.
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Selling vol with limited downside
Buying options is fun. It’s easy to risk manage. You know your downside. But buying options puts you on the clock. It’s like betting the over on a sporting event. You need stuff to happen before time expires or you lose all your money. Time decay is not your friend. It’s called “bleeding theta” for a reason.
The other problem with owning volatility (vol) all the time is that it is wrong-way risk for your trading P&L. Let me explain: Directional short-term traders make more money when things are moving and volatility is high. So you are already exposed to volatility by this reality. If vol is high, your trading will be more profitable, on average. Active traders are implicitly long vol. So if you always buy vol via options, you are adding to the risk of a boring market that makes trading harder, and bleeds you out on time decay.
Buying options requires an exciting market. If you buy calls and then the market takes a nap, you’re losing money even if you’re directionally right.
As a manager of many spot FX trading desks over the years, the best hedge for the business was always to be short vol. If vol exploded, the desk did well, and if vol was low, the desk did less well but the hedge (short vol) offset that somewhat.
Thing is, though, selling vol can be incredibly risky. If you sell an option naked, you are exposed to unlimited downside. I hate unlimited downside because it’s stressful and it creates a real risk of ruin. I never put on trades with unlimited downside. Imagine you sold MDB calls a couple of days ago.
MDB common stock, intraday since November 22
The first rule of trading is always: avoid risk of ruin.
Most people who buy options are making relatively aggressive, relatively low-confidence bets. ‘I think this stock is going to this price starting right now,’ basically.
What you’re doing in selling options is taking the other side of those trades and saying ‘I don’t think that’s going to happen.’ So from a confidence standpoint, you can generally have more than the option buyer. But from a risk management standpoint, although most retail option buyers lose their money, you’re the one who has to be more careful.
But! You can sell options and still know your max downside. Let me get right into the trade idea.
Sell MSTR volatility with limited downside
Crypto winter is upon us, and lethargy and apathy have kicked in. Trading volumes have dropped, people are questioning the use cases and the web3 and financial applications and benefits of crypto. Mania has turned into despair. Despair is different from fear in that it’s a low-vol regime, not a high-vol regime. Fear pushes prices lower fast but apathy leads to grinding, boring price action. Look at what NASDAQ did from 2001 to 2003, for example. Tedious and soul destroying.
If you think this kind of boring price action is set to continue, selling volatility is a good play, as long as the market hasn’t fully priced in the lower vol regime. Implied vol on MSTR puts is still trading around 100%, which is about its average for 2021 and 2022. The vol spiked when the FTX debacle started, and it’s back to normal now. No sign of any repricing to extreme wintery levels.
When selling vol, the way to limit your downside is to only ever sell spreads. That is, if you sell a 150 put, you need to buy a 140 put (for example) as protection. The unfortunate aspect of this is that you are buying pricier options because the more out of the money an option is, the pricier it is, volatility wise. But that’s life. If you want protection, you have to pay for it.
If we assume that MSTR is likely to remain rangebound with a downward bias, we can sell a call spread close to the money and a put spread a bit further away. This allows some room for when the next shoe drops in crypto. Here’s a chart of the stock:
MSTR daily back to late 2020
You can see that since April 2022, we have been in a 145/340 range, with most of the action between 145 and 275. This is a starting point for what strikes we might want to pick.
The further out you go time-wise, the more premium you collect, but the more impossible it becomes to predict what might happen. Think of markets as a complex system like the weather. We can forecast a few days out, but it gets harder and harder the farther you go.
50in50 is going to end when Week 50 happens around three months from now. So let’s look at selling spreads for March 2023 expiry. Here are the prices of some puts and calls that would make sense to sell if we think MSTR is going to stay rangebound with a downward bias.
BUY 240 call $15.50
SELL 230 call $18
194 Current stock price
SELL 145 put $22.50
BUY 135 put $18.00
If we sell both of these spreads, we collect: $4.50 on the put spread and $2.50 on the call spread. Market prices are wide for these options, but this is where I see them trading right now. So you collect a total of $7 if you can get the spreads on at these prices. Your maximum risk is $10 if the stock blows through either spread. So you collect $7 and risk $10 which means you are risking $3 per contract X 100 shares = $300. Risking $300 to make $700 per contract. 10 contracts would be risking $3,000 to make max $7,000.
Some words of caution
While your downside is capped on this sort of strategy, one quirk is that if the stock ends up in between your strikes, you will get exercised. You probably don’t want this to happen as it will require a lot of margin and leave you with a position you don’t want. Therefore, when doing this sort of strategy, you need to monitor it very closely about a week before expiry and if it looks like you’re going to fall in the middle, just cut the trade by unwinding both legs.
Another aspect here is the execution can be hard. You need to leave a limit order in the spread, not try to leg into the two options. If you try to leg in by doing one option, then the other, you can end up with a single trade that you didn’t want.
For more on risk of ruin in options and short positions, please see this video.
So for this trade, if we are risking $3,000, we would do 10 contracts of each spread. We collect $4,500 on the puts and $2,500 on the calls for a total of $7,000. If MSTR blows through one side, we lose $10,000 on the stock, but that is partially offset by the $7k we earned.
Please let me reiterate this is an educational Substack and not trading advice. I’m using MSTR here as an example. It is not certain you can put these spreads on at the prices I have indicated. Those are mids as I type this. Use limit orders and make sure you know what you are doing. The puts are more attractive to sell because of the high vol, even though the stock doesn’t trade with much asymmetry.
There is downside convexity in the stock because at some point MicroStrategy is worth negative dollars due to their losses on BTC. But there is upside convexity because 40% of the float is shorted and it’s really, really expensive to maintain a short position.
My view on MSTR is that it will mostly do nothing for the next few months, with occasional bursts to the downside as new shoes drop on the FTX, MtGox, and other liquidation stories. So the short MSTR position from Week 35 still makes sense but so does selling vol.
Did I mention: Make sure you know what you are doing before you do anything that remotely involves selling vol. If you’re not sure what you are doing… Just don’t.
It’s fun to buy options. It’s much less fun to sell options. Humans love fun, they love lotto tickets, and thus, they tend to overpay for options. There are almost always more buyers than sellers in equity options and for that reason, it’s often strongly positive EV to sell equity options, especially puts.
But selling puts can lead to catastrophe! So you need to do the less leveraged strategy and sell spreads.
Thank you for reading.
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Great article as usual, thanks for sharing it!
What’s your take on time spreads: selling options in the front and buying them in a further out expiration? I’m personally not a fan (to the extent that I never do it) but I‘d be curious what you think, and it should be more of a volatility play than a vertical.
The old iron condor