WRITING TRADED OPTIONS for income

Who has the edge ?

I think we first need to define “edge”. The way I see it is that it’s a small but distinct advantage that not all players have. It’s something that if the advantaged players play over and over again, and over a long period of time, the law of large numbers (law of averages) says he will win.... in the long run. Some examples of “having the edge” would be flipping a slightly biased coin or owning a roulette wheel. I don’t think that anyone here would doubt the “edge” on either of the above, yet the advantaged player could still lose a lot of money playing either... in the short term. But in the long term he will win.

So to options...

It’s much more difficult to appreciate the edge as far as options are concerned. If volatility can be thought of as a probability – then the more volatile a stock the more probable that some distant price (higher or lower) is achievable. It is on this basis that stock options are priced; Whereby the “fair value” of an option is calculated by inputting a volatility into a pricing model. The model calculates a probability, based on the input volatility, and generates a “fair value” option price. The fair value price is the price at which, whether you buy OR sell the option, over the long run, you will neither gain nor lose money (break-even).

I’ve ran literally thousands and thousands of trials by generating random stock prices from a normal distribution, and comparing the outcome against the “fair price” option, as calculated by the BS model....I can confidently say that the BS model is very accurate. In other words, if the BS model says that a 4775 straddle with 20 days to go is worth 95p at IV 9%, then if indeed HV turns out to be 9% then over thousands of trials you will break-even, not more or less, but precisely ! And this regardless of whether you bought or sold the options. Now, if you SELL the options, and HV turns out to be LESS than the 9% IV, you will WIN in the long run, and vice versa, unfortunately.

That's the edge in options (or lack of it).

I’m not so sure that you “need” a view before trading options. You could sell a naked Put (for example) then find that the underlying price moves against you (falls), yet you can still come out with a profit if the underlying fell by less than the time premium you received (premium being a function of Option Implied Volatility). Certainly a view helps, at least the right one does anyway.

It could be that options are now too widely traded to present the opportunities of an inefficient market

You could be right. It could also be that mug punter has moved away from traded options and into CFD’s and spread-betting in order to get his leverage. That may go some way to accounting for the lack of option buyers, and hence low IV. Someone suggested to me recently that maybe traded options in the USA are very popular simply because CFD’s and spread betting aren’t available there. Anyone know if this is the case ?