To explain his approach, he ran a simulation. This simulation has several assumptions that may or may not be correct. He assumed a flat volatility for all strikes when in fact it could be skewed-ie, professionals would say that the out of the money puts would trade at a higher volatility than the out of the money call. Also the Neutral Strategy involving selling the Jan strangle (25 call and 17.5 put) actually has a slightly negative delta (8). The trader just took strikes as close to equidistant from 21.5, but someone may say it is biased to the downside, and technically be correct.

But trading and writing about it are challenges for different reasons. I do the best I can.

Here are the Goldcorp (GG) Option Position Returns during different conditions:

1. unchanged @23,
2. -20% @17.2,
3. +20% @25.8

CTAB underlying assumption: The implied volatility (IV) and historic volatility (HV) are extremely high and likely to revert to more normal levels over the next few months. Therefore strategies should look to sell volatility to capture profits assuming the stock direction is correctly forecast, and reduce losses if the stock moves counter one’s assumption.

Very Bullish on GG: Buy one Jan 25 call for 2.15 and sell one Jan 20 put for 2.85 collecting .60 cents.

Moderately Bullish: Sell Jan 20 put for 2.8

Neutral depending upon your risk tolerance: Sell the Jan 25 call and the Jan 17.5 put collecting 3.95; or

Neutral: Buy one Jan 27.5 and sell one Dec 25 call for 0 cost

Moderately Bearish-sell the Jan 22.5 Jan27.5 call spread for 1.50

Very Bearish: buy 1 Jan 20 put for 2.8 and sell 2 Jan 22.5 Jan 27.5 call spreads generating a .20 credit.

Simulation Results after 30 days with GG unchanged @21.5

1. Very Bullish: loss of .17 cents
2. Moderately Bullish gain of 1.08
3. Neutral (1): gain of .91 cents
4. Neutral (2): gain of .37 cents
5. Moderately Bearish: gain of .20 cents
6. Very bearish: loss of .32

Simulation Results after 30 days with GG down -20% to 17.2

1. Very Bullish: loss 2.95
2. Moderately Bullish: loss 1.03
3. Neutral (1): profit of 1.51
4. Neutral (2): profit of .13 cents
5. Moderately Bearish: gain of 1.09
6. Very Bearish: gain of 3.21

Simulation Results after 30 days with GG up +20% to 25.8

1. Very Bullish: gain of 3.71
2. Moderately Bullish: gain of 2.11
3. Neutral (1): gain of .32 cents
4. Neutral (2): loss of 1.20
5. Moderately Bearish: loss of .94 cents
6. Very Bearish: loss of 3.97

Conclusion: The Neutral strategy is the clear winner.

Discussion: Contrary to public opinion, option trading is actually less risky than holding equity positions. Option positions let investors profit from anticipated moves in the underlying security, and also protect their capital if the stock goes against them.

Managing your risk through the use of options preserves capital. In the case of GG, a 20% stock move against you results in losses of $4,300 on a 1000 share position. An equivalent option position (10 contracts) would lose $3,440 on the downside and $3,780 on the upside on very opinionated directional plays, and only $1,250 or $940 on moderately Bullish and Bearish positions.

Quite remarkably, the non-directional Neutral strategy (#3 above) makes money in all scenarios even though the stock moves 20% against the position in 30 days. In taking this strategy, you were absolutely wrong in your assessment that GG would not move violently in one direction, but still came out ahead because option premiums erode over time. If the simulation had assumed a lower implied volatility going forward, which we believe is going to occur, the results would have been even better.

Secondly, the January option cycle has 3 holiday weeks happening prior to expiration. Market makers know this and will drop bids around the holidays allowing short premium positions to profit more than a simulation would suggest.

Lastly, premium erosion is greatest in the final weeks before expiration so if we had run the simulation 60 days out the profits would have been significantly higher.

Hope this helps. I decided to post this in a separate blog and open up the floor to discussion. Periodically, the options oracle will join in. However, I'll cut off comments here in a couple days.

FYI, we are setting up with the IB block trading desk, an operation we can use to execute large (minimum of 100 contracts) option orders using their brokers for price improvement. For an added cost of $0.25 per contract, we can call the desk and learn about the order flow in the option market and have the broker work and fill the order between the bid and ask quotes. For instance, on a 100 lot we pay an extra $25 in execution costs and save $2,500 for our clients if we pay $2.00 instead of $2.25 for an option in an illiquid security. We could also alert the desk to situations we are interested in, such as last week when we were looking to sell volatility and they could have contacted us via email, IM, or a phone call if any other players needed insurance and were ready to play up.

I succeeded in this business because I deal with the best. With the platform I have been putting in place, we’ll trade successfully against the Goldmans, the Merrills and the Morgans as well as Mr. Market. I am confident of that.

ADDENDUM:

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