re: short term v. long term options
Hi Chuz,
Suppose you want to write covered call options against a position you hold in Dell. Is it better to write short term or long term calls? We seem to have had a difference of opinion on this question when it came up a while ago. I submit it is better to write long term options because of the benefits of lowered transactions costs.
As you know transactions costs in trading options are quite high. Bid/offer spreads can easily run 6-10% or more of the value of the option. The impact of these costs depends upon how frequently you trade, accumulating against you the more you trade.
Let's assume for the purposes of analysis that the options market is efficient. This means that there is no proven strategy for deriving superior returns by playing options. The options market is a zero sum game, and in the absence of transactions costs the expected return to each player is zero. In this scenario aggregate gains would equal aggregate losses, and in the long run each player would tend to break even.
Now, given the presence of transactions costs how well is the average player likely to perform. Let's assume the average length of time an option is held is 13 weeks. If the two-way transactions costs (brokerage fees plus the spread) are 8% of the value of the option, this is the loss on capital per period. If the market is efficient, then in the long run good luck and bad luck will net out, and the player's only return on investment will be his expenses.
The player's annualized return on investment will be given by:
{(1-.08) ^ 4} - 1 = -.2836
What this shows is that the player, under efficient market assumptions, can expect to lose about 28% of his principal each year, on average. The player can, however, mitigate his losses by buying or selling less frequently. Suppose, for example, the player confines his trades to 6 month options. Now his expected loss ratio is:
1 - (1 - .08) ^ 2 = -.1536
and, of course, the player will only lose 8% per yr if he trades in 12 mo. options.
At first blush one might conclude from looking at numbers such as these that the best guarantee of one's wealth is not to play the options market. Of course, what we're assuming here is that the player is writing covered calls in order to achieve risk-reduction. It may well be rational for someone to play the options market for insurance purposes. The central issue if the market is efficient is to find a way to minimize negative expected return. There is a way to do this: minimize trading by sticking to long term options.
Geoff |
