> It's likely to be a "picking up pennies in front of a steamroller" type trade.
What does that mean?
What does that mean?
A better example is imagine that every day you bet on coin flips. Every day you go home after you're up $1. You start off with a $1 bet, and double the bet every time you lose. So for example one day, you might lose $1, then lose $2, then win $4 for a total profit of $1.
It's a foolproof strategy! You win $1 every day and you can't lose. But of course it assumes that both you and the house have an infinite stake. But if not, one day the house flips 16 heads in a row and you don't have $65536 to bet a 17th time so you go home down $65535. Kind of makes your $1 daily wins look pretty stupid now, doesn't it?
There are tons of options plays available on the stock market that have a risk profile similar to the coin flip example.
The limits are mostly because the casino can't afford to take on a 20 billion dollar bet from someone like Bezos. Even if it has a positive expected value, they will still go broke the 49% of the time they lose it.
Setting bet limits can reduce the effectiveness of the martingale strategy.
(7/8)(1) + (1/8)(-7) = 0
Generally: n = number of losses before quit.
E(x) = (1-.5^n)(1) + (.5^n)(-2^n+1)
= (1) - (1/2^n) - (2^n-1)/(2^n)
= (2^n)/(2^n) - 1/(2^n) - (2^n+1) / (2^n)
= (2^n -1 - 2^n + 1) / (2^n)
= 0
Using expected value for assess winning strategies don’t work with infinite bankroll.
The canonical example in recent times is the XIV blowup of 2018, which inversed VIX (a security tracking market volatility). So if you held XIV you basically bet that large market moves wouldn't happen - you're shorting volatility. Take a look at the graph to see how that ended up; the steamroller caught up to them! https://www.rcmalternatives.com/2018/02/why-did-xiv-implode/
No rational mind would do anything high risk low reward, unless the risk has low probability. Then it's just like selling insurance.
You can sell a put option against a stock.
Say the stock is $100 right now, and you sell a put option one month out for a strike price of $90.
The seller of this put option essentially bets that the stock will still be above $90 in a month.
The buyer of this put option is betting that the stock will be below $90 in a month.
For executing this trade, you, the put seller, receive premium, say $1. The buyer pays you $1.
You have a sold a very high likelihood bet and received $1 for taking on the risk. The buyer has bought a very low likelihood bet and spent $1 for the chance to win.
This sounds great! In the long run, stocks tend to go up so you should win this bet the vast majority of the time, collect your $1, and make the same bet again.
This is the "picking up pennies" stage.
Now what is the steamroller? The steamroller is the low likelihood but very high loss scenario that this stock or ETF absolutely crashes while you are on the selling side of this open put option bet.
If it crashes to $N where $N < $90, the put option buyer has the option or right to sell you the stock at $90, even if it is worth hardly anything. So you have now paid $90 for a stock worth less than $90. It could be $0, the company could be bankrupt. Your loss is -($90-N)+$1. (Note that because of your $1 premium, your breakeven on this trade is when the stock is at $89, not $90.)
If you put up the collateral (the money needed to buy the stock at $90) for the bet with your own money, you are out that money. If you put up collateral on margin (borrowed money) you can be mega screwed.
This is the steamroller. You picked up $1 here and and there but then you got hit with a -$20 or -$50 or -$90 steamroller when you may have not even had the money to cover it.
Yes the steamroller is very low likelihood, but you have to hit pick up a LOT of pennies in a row to still come out on top after getting hit by the steamroller.
It is important to note that there is a ton more nuance that can go into running this kind of strategy, but in general for the average person, buy and hold will always outperform a strategy like this for several reasons, not least of them being that the income received for premium is taxed at income rates, where gains from buy and hold will be taxed at capital gains rates.
Very sophisticated investors do run this strategy with many ways to handle the tail risk, and their sophisticated strategies do not necessarily stop them from getting absolutely screwed when things go bad like during the flash crash at the beginning of coronavirus. Modeling and mitigating tail risk is hard, because terrible events are not as common as normal events and when things go terribly, they usually go terribly in a way no one has ever seen before.
Selling calls would be a better example, since in that case losses are potentially limitless.
When they sell covered calls and lose the bet, the only loss is missing out on the run up of the stock.
I mostly just used the put example because it maps better to compare to a buy and hold strategy - good if market is up, bad if market is down.
It's also a well-known pennies-in-front-of-steamroller strategy that hedge funds have gotten very publicly burned on before, so anyone interested could research more.