Q: Counterparty risk on put options?

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Submitted by vegasrenter on September 18, 2008 - 12:09pm

I have some long-standing Goldman Sachs puts that have moved into the money recently. Still over a year to run on them. 2 Questions:

1. Who is my counter-party?

2. What is the risk that this counterparty can/will default on my put option?

Thanks

Submitted by stockstradr on September 18, 2008 - 12:21pm.

I don't have an answer but I do share a painfully-learned lesson on options:

WHEN you look and see your options are substantially in-the-money (net 50% gain, for example) then don't greedily hang on for MORE gains.

Instead CLOSE YOUR OPTIONS POSITIONS and lock in your profits.

I cannot tell you how many times I had 50% or 70% net paper profits and yet greed had me keep those option positions open, only to see my profit fall away as markets drifted back to center.

This week I sold almost all my option PUTS on the S&P500 as I saw they were up seventy to eighty percent net. Keep in mind I'm sure there is more money to be made on those but I sold on general principle that it doesn't pay to be too greedy.

I've been happy so far with use of options, but I stick to simple straight-foward types of options: long calls and long puts. When adding up all my net gains and losses on options trades ever made, I'm vastly in the black having made now lots of money on options.

Submitted by vegasrenter on September 18, 2008 - 12:49pm.

stockstradr, Thanks for your input. My experience with trading options has been FAR more profitable (nice multi-X gains on small at-risk $ amounts) and less worrying than when I used to practice "buy and hold" (gonad-shriveling losses) with stocks & mutual funds. However, I've found that 80% of put options that I've sold for your stated reasons went on to end way more in the money than my exit point.

Still looking for information on my original question.

Submitted by stockstradr on September 18, 2008 - 1:51pm.

My experience with trading options has been FAR more profitable (nice multi-X gains on small at-risk $ amounts)

So, here is a question for YOU: why do you think my typical net profit is 50% to say 90%, while you're claimed profit is multiple X initial investment?

ANSWER: either you have inside information (making certain profit on illegal trades) OR you are playing SUCKER BETS, which is the sign of someone quite new to strategic investing with options and who is choosing poorly in terms of RISK/REWARD ratios.

Seasoned pro's use options analysis spreadsheets to run RISK/REWARDS simulations to predict options response to a inputed (hypothetical) anticipated market move, so they can identify optimal choices to reduce risk while maintaining a reasonable reward.

You see, back in Oct '07 at the peak of the market, I could have easily purchased puts at strike prices that would have now returned me 5X or 10X...so WHY didn't I?

If you really don't know the answer to that question, then may I suggest you read this book and other similar books:

Options as a Strategic Investment by Lawrence G. McMillan

http://www.amazon.com/Options-Strategic-...

As for your original question, just look at the typical daily VOLUME of the options you are buying. Don't buy options that are too thinly traded, and don't worry about such questions when you do buy options that have sufficient daily trading volume (to ensure an efficient market for unloading them when needed)

Submitted by jficquette on September 18, 2008 - 3:29pm.

I wouldn't worry about it. Here is some info on it.

http://www.istockanalyst.com/article/vie...

Submitted by vegasrenter on September 18, 2008 - 4:47pm.

Thanks for your reply.

To clarify, the multi-X refers to individual trades, not total return. And of course I've had some options expire worthless along the way.

The bid/ask spreads and volume are fine on my positions, so should be OK there.

Will get one of option books on Amazon & then see if I can make sense of what you wrote.

Submitted by stockstradr on September 18, 2008 - 9:29pm.

I'm a total amateur at selecting options, so my methods are probably worthless, but here is what I do...

First, I don't even think about options unless there is out-of-normal (variation) market fluctuation that I am VERY CERTAIN is coming, AND others haven't priced that in yet. For example, the S&P500 is peaking at 1500, yet the housing market is collapsing, so I expect the stock market will fall dramatically.

Then...
1) I write down my hypothesis, such as, "The S&P500 will fall at least 10% in the next twelve months"
2) I look up the prices of options with expiration dates far beyond the time frame within which I think the market event will occur. (In anticipating market events, we are often biased to expect they will happen MUCH SOONER than they actually happen - we are biased by our wishful thinking! Just ask Rich and I when we originally guessed the home builder stocks would collapse!)
3) I pull down all the current pricing of a type of option, across a wide band of strike prices, and dump them into my Excel spreadsheet. Often there may be 100 rows of various options (for example, all PUTS on the S&P500 that expire 12 to 36 months out.)
4) Using steps in my hypothesis (Market drops 10%, 15% and 20%), the columns in the spreadsheet calculate: A) % return on investment; B) % market drop required to reach break-even on purchase of a particular option; C) actual net profit on one contract

Using that data, my spreadsheet plots curves of % ROI as a function of strike price, plotting separate curves for each step of my hypotheses (For example, -10%, -15%, -20% market move of S&P500)

I also plot break even point (expressed as the min % of market move required to reach break even on a particular option) against strike price.

The curves are most important: I chose options by looking over those curves. Understand, each chart with curves is for options with the same exp date, but I may create several similar charts to compare curves for different expiration dates.

I usually end up buying the options that break even after a very small fraction (as little as 3% to 5%) of my anticipated market move...and also are close to the MAXIMA of my lower %ROI curve, plotted for the conservative value of the correction (in this case 10%) that I expect.

Of course, this kind of analysis will typically steer you away from those dirt cheap out-of-the-money options...to options that inevitably have much higher nominal prices because they are in or near to in the money. I'll typically buy options that might be $5, $10, or more each. So you're talking maybe $5,000 for 10 contracts. So this is a safer way but requires larger amounts of money, compared to gambling say $500 on $0.50 out-of-the money options.

You see the reason I don't chose the $0.50 options that maybe maximize the ROI for a much larger market perturbation (such as a 20% fall in the S&P500) is that the break even point on those options will require a market perturbation that is much less likely (such as a 10% or even 20% move in the underlying security)

People think options are risky, and yes they are. But consider that I bought PUTS on the S&P500 back in Oct '07 when the S&P500 was over 1500....and yet those options had a break even that only required a ~3% drop in the S&P500!

Were those particular options THAT risky, given market and the unfolding economic conditions? I don't think so. That's why I spent 7% of my entire portfolio buying them.

Submitted by vegasrenter on September 19, 2008 - 9:13am.

stockstradr wrote:

First, I don't even think about options unless there is out-of-normal (variation) market fluctuation that I am VERY CERTAIN is coming, AND others haven't priced that in yet. For example, the S&P500 is peaking at 1500, yet the housing market is collapsing, so I expect the stock market will fall dramatically.

That's the goal, but I've been SURE and WRONG too many times to rely on this principle.

stockstradr wrote:

I usually end up buying the options that break even after a very small fraction (as little as 3% to 5%) of my anticipated market move...and also are close to the MAXIMA of my lower %ROI curve, plotted for the conservative value of the correction (in this case 10%) that I expect.

I would like to try your spreadsheet, as this is what I try to do mentally, and it's too much to keep track of.

Picking options that break even on a small favorable move in the underlying security is dead easy; the further in the money, and the closer to expiration the option is, the smaller the required move to break even. Of course, your return on the move also reduces the further you go that direction, and you lose your shirt (much larger cost per position) if the trade goes against you.

What I end up doing is sitting tight for months on end until the VIX hits the low end of its range, then looking for at-the-money long term puts that are cheap compared to those on similar underlying securities.

Sadly, my GS puts got hammered by the short-covering rally the last 2 days. Good thing they are in the money and have a year left, maybe good things will still happen. These are the kind of days where I'm so glad that I never sell short. Talk about SURE and WRONG, here I am again.

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