OTM and Doubling Strategies

Option trading is more interesting than stock trading since it possesses some its own properties. Of course, liquidation risk a problem, but long term, who cares that. I would talk a little about OTM strategy today.

1. OTM Philosophy:

Option is more volatile and risky. But this is to say under the assumption that we invest same amount of money. What if we look at the following case. Stock A we buy 1,000 share at price $20. Within 3 months, we expect it to move between 18-22. Then you expected result is -2,000 - +2,000. Let's do this by another way. We buy 20 contracts call options with strike price 21 at $0.1 each. This costs $2,000. So your expected result now is -2,000 - +20,000.

Yes, this is too weak a case to show some dominance. We can attack from many angles such as "you can't find so cheap OTM options if that information is priced in, you can't do this without consideration of operational risk which might lift the price much, it should be more prone to go down if OTM is so cheap, etc".

For small investors, I hardly believe so called statistics would take effect. We are betting anyway and most of the time, worse case analysis is more proper. However, portfolio holding or long-term investment do give us some confidence in using econometric methods. But this seems prohibitive considering quite limited budget.

OTM gives you hope.

Doubling strategies, which were adopted by Leeson at Barings Bank, can be used as a demonstration. By using the same policy, OTM can achieve the same P/L as betting on stocks. Moreover, OTM distribution is asymmetric and often fat tailed. I would say it's even a better bed for doubling strategy than real-meaning stocks and also this is what Leeson actually did. For academics, you can refer to Shreve's example.

So now you can use portfolio analysis and numerous econometric methods. Essential but still superficial. Since it doesn't answer one question: Where are you finding these OTMs?

2. OTM Pick:

Several experiences to share.

1) Pick one which is OTM due to macro- but NOT individual factors:

Like some retailing brand goes down because of macro factors like the warm winter causes the sales down in holiday season. Since all other go down as well, it's still yet not enough to say it loses its advantage. And are you expecting this seasonal effect or abnormality to last? Even abnormality does last, given a better company, it should adjust better than others. However, if a company is down due to individual reasons, it's a little risky. Like USG, it has been around $55 for a long time. Only catalyst during this period is Buffett's stake raise. This helped a short wave and faded quickly. Anyway, 99% are not Buffett and not passive fund managers.

2) Watch out time decaying:

Even you are lucky (at least you should think so yourself) to find some candidates. Don't rush into them before you make some investigation. You have to know how much time it may take to turn you OTM into God-blessed treasury. Don't overlook time decaying effect even you are not rejecting short-term play. And of course, if you are more academic, you can do periodic review and form some first or second order hedge portfolios.

3. Some Principles:

Though I am not a principle believer, seemingly it indeed has some psychological effect.

1) Asset allocation:

Let's say we make following allocation: 50% as reserve, left assigned 10-20% to each bet. So if you have $20,000. Then you can reserve $10,000 and make 10 bets, each with $1,000.

To keep reserve is to capture new opportunities when appeared. To assigned small proportion to each bet is to assure you are not absorbed by zero state too soon.

2) Early Bird:

Historical data shows overreaction often appears at heavy volume moments. And so does OTMs. So to find good candidates, keep an eye on news and a regular watch list.