Bed Bath and Ben's-Broke (Patreon)

You never know where you are on this graph...

And I'd argue the graph looks more like this....

The markets can be so fucking deceptive.

Here's a relatively boring (but relevant) example with straddles vs strangles. 

A straddle is an option strategy where you buy or sell a put and a call with the same strike and expiration. Assuming we sell a straddle, the trade makes money if implied volatility is greater than the subsequent realized volatility.

A strangle is a strategy where you buy or sell a call and put with different strikes but the same expiration. Assuming we sell a strangle, the trade makes money if implied volatility is greater than realized volatility. 

But our win rate suggests something completely different. 

Both of these structures have the same expected value. Remember, the mispricing of individual options you're putting into these structures determine whether a trade is good - not the structure itself. 

But while both structures have the same EV, their win rates tell a different story. 

Below is an excerpt from Positional Option Trading. The author simulated 10,000 paths of both a short straddle and short strangle, each with negative expected value. Here we can see the return distribution of each. 

                                             Short Straddle Return Distribution

                                              Short Strangle Return Distribution

The short strangle results are deceptive. While this is actually a negative EV trade,  we make our max profit a significant percentage of the time. 

It's easy to mistake good luck for brilliance when using a trade structure with a high win rate. If the short strangle portfolio would have been mine at the beginning of my trading journey, I'm certain I would have been convinced I was a young Warren Buffett. 

I know this is kind of complicated and boring, but I wanted to use it as an example of how deceptive the markets can be.

In the beginning of my time trading options, I was making this exact mistake. Thinking my mode return was my mean return.

Selling deep OTM options, collecting massive short-term profits, and watching the entire thing implode, leaving me with less than I started with. 

While now I feel more equipped than ever to make meaningful returns trading, I want to remember that there are plenty of known unknowns, and unknown unknowns. 

That was an example of just one of the many ways the markets tricked me into thinking I knew what I was doing. 

In reality, I was just being fucken stupid. Not understanding fully what I was trading, why it was supposed to work, how it was supposed to make money, or where I was (idk why).

One Tactical Note on Straddles vs Strangles

Euan Sinclair, the author of this book simulated these two portfolios to demonstrate an important point - 

Straddles are usually a better trade structure, because they give you more feedback on whether what you're doing is actually working. 

While they'll never make the max theoretical profit (not profit in terms of long-term expected value, but "premium capture" on an individual trade) in the same way a strangle will, they'll demonstrate to you whether or not you actually have edge in your trades. 

Long story short.....

If you're trading volatility, use straddles instead of strangles.  

Position Sizing

Position sizing has always been one of the most complicated aspects of option trading to me. 

Let's say you found an edge in selling biotech options around press releases. You might ask the question.... 

Based on the historical data as well as my theoretical understanding of this situation, options should be overpriced by x on average. How large should I size this trade? 

For a second, assume the most simple sizing scheme - 

We have $10,000, and we're going to bet 10% of our portfolio on each trade.  

But is that 10% $1,000 in option premium, or $1,000 in margin being tied up in our account? 

But this is only the beginning of the fuckery.   

The "5% of your portfolio" or "10% of your portfolio" sizing scheme might work for diversification purposes when buying stocks, but it's not great for trading. Generally, if we're trying to maximize our compound growth rate, we want to size trades according to our edge.....  

.....which is rather inconvenient being that the edges we're trying to exploit change over time. They make money on average, but not always. We never know what our edge is right now, only what it was historically.

I don't have a good solution for this right now. My trade sizing has been terrible up until this point, and coming up with an unambiguous sizing strategy is something I really want to prioritize in 2023. 

Some of you guys mentioned Kelly. I've been trying to learn more about it, but using kelly with continuous non-normal outcomes - for example when trading options - is so fucking complicated. 

Bed Bath and Ben's-Broke

                                12 days into 2023 and already feeling the pain.  

At least I was able to get a cool YTD performance screenshot :(

While it is painful, this is actually a good thing. We have to remember that this is the reason the strategy has a positive expected value. 

Stomaching these massive losses is unpleasant, but it's also the reason you get paid to do it. 

It restores my faith that the meme stock phenomenon isn't dead. That instills some confidence that my edge here is going to persist for the time.

Most risk premium trades involve accepting some kind of highly negatively skewed return distribution. 

That's just a fancy way of saying you're going to have a lot of small, capped gains followed by massive uncapped losses - Imagine selling insurance, or owning a slot machine. 

We know how much Wallstreetbets loves playing the stock market likes it's a slot machine, so we get paid for providing them with one. 

However, whether you want to think about it as insurance or a slot machine, the conclusion is the same - you're going to have to shell out a massive check every once in a while. It's probably going to fucking suck. 

The difficult thing is that in risk premium trades you can't allow yourself to step back from the spooky situation. At least if your goal is to maximize the expected value of your strategy.  

In index puts, the risk premium is largest when the VIX is highest. IE when scary crashes are happening, you get paid the most for providing crash insurance.

Similar to how when you see a situation where you really want to buy options that's probably where you need to sell options..... 

When more than anything you don't want to sell another BBBY straddle, that's probably when you need to sell one. 

I hope some of you guys bought these BBBY options I sold! At least someone can get paid (in the short term. In the long term I'd highly recommend not buying meme stonk options) 

2022 Final YTD Performance

Portfolio Update 

This is somewhat misleading because I had another ~$4500 contribution (thanks for that btw it's gone now) in the beginning of January.

Just in case any of you were wondering why my YTD performance is so terrible but my portfolio value has barely changed since 2022.