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The bull is dead, long live the bull

Posted by Yogesh on Tuesday, 14 October, 2008

One of the biggest misconceptions that exist in the world of options is that 80% (some claim it to be as high as 90%) of the options expire worthl

JUST STAY OUT

JUST STAY OUT

ess. So, in the long run, it’s the option writers and not option buyers, who end up making money. In reality, nothing can be more preposterous than this.

Let’s take a hypothetical example, where because of a sudden fall in prices, a large chunk of call options ended up being worthless. As a result, the option writers pocketed the premium and the buyers ended up with losses.

But what happened to the put options? It’s simple logic that when prices fall, the value of puts rises, forcing their sellers to run for cover, which benefits the buyers. So, logically, if calls end up being worthless, puts become valuable and vice versa. So, it’s absurd to conclude that in the long run, it’s the option writers, who make money.

With regard to the very-out-of-themoney options, it’s a fact that unless the price movements are very dramatic, a large chunk of the out-of-the-money options end up being worthless. But is it worth writing those?

In his book, Fooled By Randomness, best selling author Nassim Nicholas Taleb writes, “Option sellers eat like chickens and go to the bathroom like elephants” . What he basically means is that option writers fall in the trap of making small, although regular profits.

But when they make losses, they simply blow up! What he wrote has now come back to haunt option writers, particularly those of puts, as in the lure of making small easy profits, they have ended up digging their own graves.

V for volatility V for violence

Over the past week, volatility has assumed an altogether different meaning. While superlatives have always been overused in the world of financial journalism , if one could have ever used the term ‘panic’ , it is now. At the time of writing this column, the CBOE VIX was quoting above 75 — that’s over 50% higher than its life-time highs!

Even ETIG’s Smart Money Ratio (SMR) has shot up wildly to levels it had never seen before and sums up what’s happening in the world of equities.

If that was not enough, at close on Friday, the put-call ratio (PCR) of Nifty option contracts expiring in October had collapsed to 0.58!

The only other occasion when the near month PCR had fallen lower than this level was on June 14, ’06, when the Nifty had bottomed out at a June PCR of 0.56 after the correction of May-June ’06.

FRESH TRADE

Last week, we had suggested going short full throttle in Nifty futures, if the market were to open below 3800.

I hope you have followed our recommendation and are now sitting, with amazing profits of close to 500 Nifty points. So, irrespective of whether we gap up or gap down on Monday, just book your profits and sit tight on cash; may be donate a bit of it to some hapless bull around you!

For, this is getting beyond bulls and bears and profits and losses; the very existence of free market capitalism seems to be at stake. JUST STAY OUT.

Source Economic Times

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