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Hi I am new here and I was referred here after reading this article

http://www.fool.com/news/commentary/2006/commentary06102513.htm

This article recommends trading option spreads. I don't get it -

1. The expected profit of a fairly valued options trade is zero at the moment the trade is initiated - ok.

2. Options buyers are a lot like casino gamblers -- sure to lose over the long run. - huh?

If you do the math using the given figures: ($0.85 x 0.66) - ($1.65 x 0.34) = 0. So basically you're doing an EV neutral trade, before considering commissions and spreads. Huh?


I totally do not get it, and would love clarification.


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<<Options buyers are a lot like casino gamblers -- sure to lose over the long run. - huh?>>

OTM options buyers are purchasing time value, which decays. Buying a decaying asset is a fool's game. A 2004 Ibbotson Associates study of index option prices found that "option writing can be very profitable." According to this study, certain index options (such as the S&P 500) have historically been overpriced.

http://www.ibbotson.com/download/research/CBOE%20040728%20final.pdf

<<So basically you're doing an EV neutral trade, before considering commissions and spreads. Huh?>

I only recommend putting on spread trades with limit orders at fair value, so the spread issue is not relevant. Commissions with a discount broker are negligible and thus are also not relevant. The trade is EV neutral only at the instant you put it on. After a little time passes and time decay occurs, the trade becomes EV positive for the options seller.

Also keep in mind that the trade is EV neutral only when measured against the market's implied volatility figures. These figures are mere estimates and will likely turn out to be different from the actual volatility. So a person with a variant perception on volatility can enter a spread trade right from the start with an EV positive position (from her perspective).

Trading stocks involves the same concept of variant perception. Every stock trade that occurs has a buyer and a seller who think they are getting a good deal. One of them turns out to be wrong.

Hope this helps Brian.

Jim


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The trade is EV neutral only at the instant you put it on. After a little time passes and time decay occurs, the trade becomes EV positive for the options seller.

If I sell you an option and I have your money, it seems my "expectation" in the financial sense must be that I must give you your money back at some time later PLUS the risk free rate of return as interest I pay you.

I believe what you mean to say is "after a little time, the EV becomes positive IF THE UNDERLYING STOCK PRICE STAYS FLAT." But of course the underlying stock price is not EXPECTED to stay flat, it is expected to rise. Indeed, every intuition in my body says it is expected to rise at exactly the rate that would keep the EV of your position tracking the risk free rate of return. So if you are net short, I would say the information in the options prices is that you EXPECT the stock price to follow a trajectory that has you effectively paying interest on your short position at the risk free rate of return.

As I write this I realize that each different strike price option will generate a somewhat different "implied stock price" over time. This is probably going to rise to the level where I'm going to need to think about it. It would seem you ARE buying DIFFERENT expected stock price trajectories with different options. I don't know what you would do with this.

So the only reason I am posting this at all is so I might remember it long enough to look into it.

R:
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<<I believe what you mean to say is "after a little time, the EV becomes positive IF THE UNDERLYING STOCK PRICE STAYS FLAT.">>

Not exactly. The EV becomes positive if the underlying stock goes down OR stays flat OR rises to the short strike. That's the beauty of selling time decay; you can win in many different price scenarios whereas the options buyer wins only in one price scenario.

Jim

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