February 28, 2017

Must read article: Option Writing – Promises and pitfalls

...keep in mind the following statistic:

  • 95% of OTM options expire worthless
  • Prices stay within 1 Standard deviation 68.2% of the time, within 2 Standard Deviations 95.4% of the time and within 3 standard deviations 99.7% of the time.

Keeping the above statistics in mind, does it make sense to have un-hedged unlimited risk strategies of selling naked options or any strategy like straddles and strangles with unlimited downside?

The back tests and empirical evidence suggest, you can make money doing that, however

“The Empirical evidence does not work in case of FAT TAILS”

This simple line is very hard to register. Option sellers write code after code, extract nth amount of data and back-test their code to draw their conclusions. They figure out ideal dates to expiry (dte), ideal volatility when to short, ideal time to square off the position based on past information.

The problem is not with the process of back-testing. Their process is very robust. Problem is the source where they are applying the back-test on. The back test is not foolproof.

If you ask the wrong question, you cannot get the right answer. The Gaussian distribution curve on which the Black Scholes model is based, works in mediocristan, a term used by Nasim Taleb.  It PRESUMES that  financial world is governed by normal distribution and a 5 standard deviation away moves are rare and will have mild consequences.

Read more at http://www.stoicinvesting.com/2016/07/option-writing-promises-and-pitfalls/

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