Comment by leelin | Hacker News Reader

Comment by leelin | Hacker News Reader

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You can lose because the option price takes into account how much the market expects the stock to move (the implied volatility). Your proposed strategy is going long volatility and delta-hedging to maturity.

Others have already chimed in, but I'll use a real life example. At the close yesterday, NFLX was trading around $100, you could buy a put option to sell with strike price $100 expiring December 18th 2015 at a price of around $7.00 a share.

Using your strategy, you would buy one contract and simultaneously buy 50 shares. Each contract comes in multiples of 100, so your put option covers 100 shares and you own 50.

If you didn't manage the trade at all until December 18th, you'll make money if NFLX is below $86 or above $114. You'll have lost money if it is anywhere between the two numbers, because the actual realized volatility of the stock did not live up to the implied volatility price (and for many reasons that is usually the case).

Even if you did manage the trade throughout, there is no easy free lunch. You could set a rule to close the trade the moment NFLX crosses over $120 or under $80, but then you'd be giving up the upside that it hits $150 or $50.

I'm a beginner to this field, but using a real world example sounds like a good way for me to learn, so thank you for putting it together leelin.

I'm a bit confused by some of the terms used (such as implied volatility price, can you explain what this means?), but assuming I've followed enough to understand... If the put option covers 100 shares, why would you only buy 50? Wouldn't it make sense to buy 100 shares?

You buy 50 shares, because in your proposed strategy you want to make money whether the stock goes up or down. Because the option strike price and underlying price are the same, the appropriate ratio of underlying stock to options is about 50% if you want to be neutral to the future direction of the stock movement (delta-neutral as they say).

If you bought 100 shares with 100 covered, then you are purely betting the stock is going up by more than the option price. You would break even at $107, but lose on anything lower.

Implied volatility is the amount the stock is expected to move as implied by the price the market is charging. Sometimes it is easier to think of an option price in terms of volatility rather than raw dollars, especially when you are making trades of the type you proposed.

In the Netflix case, the current price of the option "implies" that the stock will move plus or minus 3% per trading day; if it moves more, say 5% a day, you are likely to make money.

Of course, thinking of options in this way also means you are on board with a ton of assumptions in modern options pricing theory, and lots of smart people point out flaws and objections.

Okay, I understand about the 50 shares now, and the rest of your descriptions of how this work makes sense too, thank you for explaining this clearly.

Going back to NFLX example, I have one more question. You said that NFLX was trading at $100 yesterday, so where does $7.00 a share come into play? Are the shares not $100 a piece?

$7 is the option price. The interest in your earlier example.

Ah, thanks kasey_junk.

Okay, so I thought I knew enough to work the NFLX example, but I still came up with some mistakes. Unexpected values shown in blue here:

http://oi61.tinypic.com/2h71ndh.jpg

I've probably made a fundamental error, what am I missing?

Don't execute on out of the money options. IE you eat the $700 in fees but you don't actually trade the underlying stocks they represent.

Oh, so you can just pay the fees, cancel the put option, and keep the stock you bought at the beginning of the process?

Or really sell the stock you bought at the beginning of the process if you want to take profit.

Yes, that's one option.

So just so I understand, what flexibility do you have as the purchaser of the put option when it comes to selling. From what I understand the purchaser can choose to sell between the put option maturity date and the put option expiry date, is that correct? Are these typically the same date? Would you pay a premium to have a wider gap between the maturity date and expiration date?

The major difference between OTC and exchange traded derivatives is that exchange traded ones have set contracts that standardize these things. What those set contracts are is exchange to exchange and product offering to product offering.

You can take a look at CBOE's product web page to get an idea about the different kinds of options products they offer.

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