Dear Traders and Course Participants,

When I ask how are you doing, everyone says: No good! How come short guts does not work well in this super bearish high volatility market?

We have compared the performance on a few short guts traders and we found out most of them lost about 5-10%, and a few still make 1% despit the sharp correction. Let us analyse this:

1. The market corrected sharply, even though you are constructing short guts on ETF, the delta loss is still there.

2. Many still do not understand delta loss fully. As the underlying plunges, the short put is far deep in the money and delta has become 1. That means, every $5 drop in underlying price, the short put is losing $5.

3. As the stock drops nearer to the short call, the short call becomes near the money (NTM) or at the money (ATM). Any ATM options have only a delta of about 0.5 to 0.6. That means the short call is gaining $2 or $3 onlyfor every $5 drop. This is called delta loss. The loss of short put is more than the gain in short call. It is a temporarily loss which can be compensated by time value.

4. When you buy back the short call, you have to sell into another call which is at least 2-3 months away. Options with 2-3 months expiration date will have a time value > $200 or $300. Time value will heal the wound in 1-3 months.

5. We noticed traders who rolled the short call when the stock was $2 away from the strike price did better. For example, one constructed a 125 call and 135 put for SPY. When SPY dropped near $127, they bought back the 125 call and roll into $123. When the SPY dropped near $125, they rolled to 121 call. They did much better than those who rolled over when the stock dropped near the strike price.

6. Rolling early before the stock reaches the strike price has distinct advantage: The short call would not become too near in the money and delta would not drop to 0.5. Those traders who rolled early, most of them, were notching +1% to -3%.

7. Many traders caught off-guard by Tuesday opening gap-down, Most underlyings dropped out of the strike price. That is why we always like to adopt a more bearish view, even though we are trading non-directionally. We always sell the call further away from the underlying than the short put. For example, if SPY is at $125, we will sell 118 call and sell 128 put. As the stock drops, the delta increase in 128 put is not as menacing, but the delta improvement from 118 call is a welcome gift. But you may argue, if the stock goes up, the 118 call call is stronger than the 128 put, and we have a loss in delta again. Yes, you are right. But as the stock or market goes up, volatility drops. The loss in delta is compensated by lower volatility.

8. As options writers, we like to sell at high volatility and enjoy rich time value decay as volatility dries up. The present scenario is not too friendly to options writers. But the volatility will ease a bit after every storm. That is the nature of trading, it is human nature too. If the volatility keeps rising, do not panic. When you roll your options, you are selling into high volatility as well. The repair takes slightly longer only, probably 2-4 months.

9. Most losing positions will take about 1-3 months to earn back the lost 5-10%. Time decay will kick in slowly. Imagine if you are holding a stock, you will not breakeven if the market stays flat or goes up slightly.

10. Most short guts traders make the same mistake. Most like to sell into front month (current month) because not many traders like to sell into back months (further in the future). Many traders thought selling into 3 months from now means, no income for now until 3 months later. Time decay happens everyday, it is just slower in the beginning. Options writers earn time value which is decayed everyday.

11. Do you also know that, the delta for back month's options is not as menacing as front month's options? We notice short guts traders who sell 3 months in advance lost only 1% during Monday-Tuesday meltdown. They all recovered and up by 2% today, even though the market was flat today. Decrease in volatility helps options writers.

12. Here is one suggestion: If you afraid the underlying you constructed short guts on will drop again and do not want the delta too strong on your short put, try this: Sell Nov put, sell Sept call, or you still like front months options, Sell Sept put, Sell Aug Call (Sell back months put, sell front month call). Back month's options delta will not increase much as the stock drops.

Thanks everyone who informed and updated us everyday on the time value collection and correction. With statistics and comparison of portfolio construction, everyone learns and adopts a better system in short guts construction and options writing.

Etradehome.com

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hi sun,
sorry one question here. based on your number 7 point, wouldnt volatility goes up also when the stock advances? i thought volatility is a measure of how volatile a stock is? pls advise, thank you. :)

rgds
ky

7. Many traders caught off-guard by Tuesday opening gap-down, Most underlyings dropped out of the strike price. That is why we always like to adopt a more bearish view, even though we are trading non-directionally. We always sell the call further away from the underlying than the short put. For example, if SPY is at $125, we will sell 118 call and sell 128 put. As the stock drops, the delta increase in 128 put is not as menacing, but the delta improvement from 118 call is a welcome gift. But you may argue, if the stock goes up, the 118 call call is stronger than the 128 put, and we have a loss in delta again. Yes, you are right. But as the stock or market goes up, volatility drops. The loss in delta is compensated by lower volatility.

Good day KY,

If you use VIX (broad market volatility), you will notice VIX is decreasing as the market goes up. You could key in ^VIX in Yahoo Finance and check on its pattern.

As the market moves up, they are not many sellers. Only sellers are panicked, not buyers. They are no panicked buyers, only 'kiasu' buyers.

As the market tanks, all sellers are running wild with or without their pants. This drives up the volatility.

In general, volatility drops as the market goes up, especially on ETF and most single stocks.

Only for some stocks, especially those have just started their bull run, or just after the good IPO price, volatility goes up as the the stock moves up. For example, when Visa (V) was just listed, volatility was rising as the stock moved up. When the stock dropped slightly several months ago, volatility decreased rapidly. That happened when it was newly listed. We do not know whether it is still the same now.

Thanks for the question. Keep collecting time value, don't give up.

Etradehome

thanx sun for your clarification. :) sure! we'll just keep selling... :)

wow this is very informative, even with my expertise in options it still take me sometimes to digest and I still blur at some parts. Maybe time for recourse again. Haha but what is important, just make money.

I do not sell front month also, front month time decay is at the maximum so it is good for options seller but what is missing from this is that when you sell front month options, the time decay has already kick in and you have to sell closer / nearer to the market which in term is increasing your risk.

Here is 1 suggestion if you are planning to sell front month for $1. Look for a next month $2 and see how far off you can sell. Your income remain the same you are still collecting $1 a month except this time u collect $2 at the end of 2 month instead of $1 every month.

I normally sell a options 30 - 90 days. I try not to go beyond 90 days probably because I am trading futures options and it is more volatile and also futures options you can sell really far off so there is no need to sell so far away.

Good luck everyone

Hi Mr. Sun,

very enlightening email. Been trying to get you through your old email. Its been a while since I posted. Been 2-3 yrs since I took the course but no good progress yet. Have not even earn back what was lost still.

I have only been using short guts too. Guess must have miss out some of these important points that you stated.

HAve a quest: For the position not rolled over, when there is assignment at the end of the month, I construct a new position which should be 2-3 months away?

Thanks.