Trading System Design. The Option Selling Report

Transcription

1 Trading System Design And Other Trading System Analysis Author: GoTradeSignals 1

2 U.S. Government Required Disclaimer: Trading financial instruments of any kind including options, futures and securities have large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the options, futures and stock markets. Don t trade with money you can t afford to lose. This training website is neither a solicitation nor an offer to Buy/Sell options, futures or securities. No representation is being made that any information you receive will or is likely to achieve profits or losses similar to those discussed on this training website. The past performance of any trading system or methodology is not necessarily indicative of future results. Please use common sense. This site and all contents are for educational and research purposes only. Please get the advice of a competent financial advisor before investing your money in any financial instrument. 2

3 Introduction Welcome to the Option Selling Report. With this model you, the trader, will be able to do what many successful traders are already doing, extract money from the financial markets. This model is not rocket science, or the most complex strategy you can find in some of the outstanding books out there. But having a clear cut, and expressed, trading plan is most of the reason traders are successful. And success is what you want. This report culminates with an explanation of the GTS Method for iron condors. The method generates a similar credit to an iron condor, and has a similar expiration graph (red line), but the active risk profile is more favorable at initiation, as well as long vega at the put 3

4 wing, which would aid with a sharp market move lower. However, the iron condor strategy outlined in this report will do well on its own in most market years. Below is the risk graph of the GTS Method for the iron condor. The platform is a great platform and provides some of the images in this report. 4

5 This report can be grasped by anyone with an interest in trading. However, the more versed one is in the terminology, the easier read it will be. If someone has an interest in trading, but not sure of an interest in learning to trade, they can trade hands free with By working with our approved brokers, trading can take place with no effort by the account holder. The account is funded in the trader s name, and publishes the signals to the broker; the broker takes care of the rest by autotrading for the account holder. 5

6 is not an investment advisor but is an autotrade publisher of trading signals. No specific advice is given, signals are available to all subscribers. From a mathematical perspective, the terms which describe the inner working of options are referred to as the Greeks. While the option Greeks are not referred to a great deal in this report, there are some options terminology which may be unfamiliar. But if you are just starting out, a quick glance at some of the tools out there will make this an easier read than it is. If you need a primer, drop us a line, This options trading technique, as presented, takes as little as $2000 to implement. There are many ways to trade with less capital, but commissions become more 6

7 consequential, and this drags on expectancy. Expectancy is the calculated mathematical conclusion of a series of trades. When trading equities, more contracts per position will mitigate the impact of commissions further. In our examples, and for simplicity, we will trade one contract at a time. This sets margin requirements at approximately $2000 to get started with this model. The target profit potential per month is approximately 8% on margin before transaction costs. The average monthly potential will be much lower when factoring in losing months, likely closer to 4%. Winning every month will not occur, so be prepared to take some managed losses. 7

8 Margin rates for short equity option spreads are fairly easy to calculate as the spread amount minus the credit received multiplied by $100. For simplicity the spread can simply be considered the margin requirement. works with great brokers who autotrade for their account holders, and can answer any questions you may have. 8

9 The Debate Option selling vs. buying can often be a volatile debate. The debate is likely not about agreeing if most out of the money options expire worthless or not. It is actually a question of options being efficiently priced or not. From an objective standpoint, a case can be built for both sides of the discussion. The parallels between the options selling business and the insurance business are numerous. Option sellers are essentially selling insurance. Insurance companies, as a whole, can do very well with forecasting and actuary tables if the premiums are rich enough. 9

10 If insurance premiums were priced efficiently, and net revenue matched net insurance claims, plus the cost of doing business, the incentive to be in the insurance business is greatly reduced, if not completely eliminated. Therefore, insurance premiums are modeled with the ability to generate a profit over and above what their actuary tables indicate is needed to cover claims, and thus, the incentive for the insurance provider, and their respective shareholders, to continue in business, remains in tact. This is part of the rational of proponents of some options being regularly mispriced. On the other side of the coin, many argue there is no expectancy for options, and they are priced efficiently. Therefore, if options were randomly sold over a long 10

11 enough period of time, the expectancy would be $0, less transaction costs. This would exclude any trade management or exit techniques. If options prices are always efficiently priced, then trade management is the main potential edge for the trader, and that can be a daunting thought. The question to be returned to, then, is whether or not there is a long term profit built in for the option seller, similar to what the insurance companies are pursuing. There are many factors to this answer in terms of the trader, strategy used, exit techniques, hedging techniques, market used, and more. We re going to let the debate go on without us for now, and dive into the model. 11

12 Objective The objective of this report is to introduce a systematic options selling model, which can be used by most traders with a basic understanding of options, for a U.S. equity index, or a derivative thereof. A brief note on system traders. We are an affectionately dysfunctional bunch, methodical and analytical, and often isolated due to our trading style. Many of us are hardwired to feel more comfortable trading with quantified rules, but will hopefully loosen up when needed. Discretionary traders are probably less enthused by systematic rules, and they might be better suited viewing the system as a guideline. 12

13 As with the last report on Trading System Design, this report will be short, even shorter actually. In this case this is likely positive, as some traders do not make good writers. The information in this report is far from exhaustive, and there are some great books out there with much more advanced concepts and definitions which are truly enjoyable to read. 13

14 Markets The underlying instrument used in this report is the ticker SPXPM. SPXPM is the newer underlying related to the SPX, but the options are electronically traded, and appear to have significantly smaller spreads when compared to the SPX. SPXPM options expire the evening of expiration day, and not at the open. This gives the options essentially one more day of life, but there are no surprises as to where the market is when the options expire. And this is an issue with the SPX as the set price can be over one daily average true range away. The process of establishing the set price is one of the biggest ways in which large players manipulate the market and it likely should be changed. 14

15 However, other instruments can be used as a proxy for the S&P, such as the ES, SPY, the mentioned SPX and others. But the trade structure should look very similar across the board. Compared to these other markets, commissions incurred using the SPXPM can be lower and the bid/ask spreads are typically lower than the SPX. For now there is much lower volume options volume on SPXPM than on the SPX, but fills don t seem to be an issue. As mentioned, SPXPM is electronically traded and maintains the same size of the SPX. We are somewhat averse to pit traded markets in general because they can often take a long while to get a fill, and some of those fills can be unfairly poor. The electronic markets are 15

16 actually improving spreads and liquidity in all markets. There are times, however, when pit traded vehicles are more than viable and are the best vehicle to use, it just depends on the preference of the trader. The options world has changed so rapidly recently with the advent of end of month options, weekly options, and now weekly options available more than a week out. With so many tools available, adjustment possibilities have really multiplied. At the time of this writing, SPXPM only offers serial options, which are the options which expire on the third Friday of the month. However, SPX offers weekly and quarterly options and these can always be used for trade initiation and adjustments as well. 16

17 Options with less than a week of life left have theta levels of nearly violent proportions. If weekly options are viable, it would offer 52 expirations per year. The trade off would most likely be the lack of a cushion from a strong market move. Some traders achieve impressive weekly results by selling options, and every once in a while there can be a big hit to performance. 17

18 Trade Structure There are many ways to trade. And just about any way can be tweaked to be successful as it really depends on what works for the individual. In terms of attempting to make an attractive absolute return in equity markets, spreads can be used similar to the technique presented here. The reason spreads are utilized is because of reduced margin and defined risk. The margin requirements for uncovered option selling in equity markets are substantial, and the risk is much less defined. Some traders using spreads refer to it as a bribing of the margin 18

19 gods, as the lower margin requirements are so significant compared to uncovered margin requirements. However, uncovered option selling is much more viable in futures markets, like the ES, SP and others, where margin requirements are based on probability and risk utilizing SPAN. Selling uncovered premium is the most efficient way to produce a credit, and the most risky, in terms of theoretical max loss, and vega (implied volatility) exposure. 19

20 The particular strategy in this report uses vertical spreads. A vertical spread is buying and selling different strike prices in the same month and underlying. It is often used as a risk management tool and either generates cash into, or depletes cash from, the account. As discussed earlier, uncovered option selling is usually considered more risky than selling premium via vertical 20

21 spreads. Covered calls, a fairly well accepted strategy, has a very similar risk profile to a written uncovered put option, and yet bafflingly, it is encouraged by many brokers. This is likely because the broker has no perceived risk. Regardless, if leverage is used, extra care is necessary, and all trading should be taken seriously. 21

22 Technology There are some great trading platforms available to the independent trader, many at no cost. There are also a number of charting websites which stream at no charge. For quick static charts on the fly, I have used for over a decade. Some of the images in this book are from Bigcharts and for this reason we are recognizing them. To actually trade well, tools with more features need to be used. We use other platforms for real time trading and streaming data. Drop us an and we may be able to steer you in a direction for various tools. If you have a great tool, we would like to hear about it as well. 22

23 The Options Selling Entry The basic building block of this strategy on the SPXPM is the Iron Condor. The Iron Condor requires a vertical spread with calls, and a vertical spread with puts, and combines them to complete the condor. They share the margin requirement, and only one side can be at risk at a time. The spread distance is 20 points for both vertical spreads, which is what enables the sides to share a margin requirement. To find which strikes are to be used for the Iron Condor, find the vertical spread for the calls or puts which nets approximately.90 per side. This will net a combined credit of approximately 1.80 for the complete Iron 23

24 Condor. This will generate $180 on approximately $2000 in margin, resulting in generating 9% on margin. Because actual prices are used to discover which strikes are used for the entry, the trader is not using probability analysis, or a multiplier of the standard deviation, or delta etc, to choose the short strike price. But in all reality, those techniques should result in very similar strikes with short strike deltas at approximately.16. For this technique, choosing of the strike price is purely based upon the price of the options, which is not uncommon. The goal is to set up both a call and put vertical spread with days left before expiration. Options can be written with less of a duration before expiration. But because U.S. equity markets tend to fall significantly faster than they rise, it is not advisable when 24

25 considering put exposure. Put another way, when a sell off does occur, a standard deviation move from when the put option was sold is very possible. When trading iron condors, the trader does not want the underlying anywhere near their strike price. Gamma (the rate at which an option s delta will increase with a move of the underlying) will simply grow too rapidly with a severe market drop. Some traders refer to this as gamma gearing. The GTS Method attempts to compensate for this potential move by being long vega at the wing. The steps to develop the trade structure are the following: Pull up an option chain on or another site, for the SPXPM. Look at the options expiring in days. Find the 20 point put spread with 25

26 a value of at least.90, usually about two standard deviations away. The call entry uses a similar concept. Look at the calls on the SPXPM options chain with the same expiration date. Find the 20 point spread with a credit of no less than.90. The calls will likely be set up approximately one standard deviation away. 26

27 Here is how the numbers line up trading 1 contract: Vertical Put Spread credit =.90 Vertical Call Spread credit = x 1 contract (puts) = $90.90 x 1 contract (calls) = $90 Total premium = $180 $180 / $2000 (premium / margin) = 9% Courtesy of the following image is how the trade visually appears at initiation. Notice the time laps lines showing the profitability due to time decay. Upon initiation, the trade has a profitability range of 240 points. As time decay (theta) occurs, the range of profitability grows: 27

28 Later in this report we will be discussing the GTS Method of modifying an iron condor to improve the risk:reward characteristics. It transforms the risk graph to look like this: 28

29 With some slight modifications, the trade is long vega on the put side, giving the trade staying power for a large move lower. Max risk is also greatly reduced. Be sure to read the section on the GTS Method for more info. 29

30 Exit The exit for the vertical spread is also price based. If the vertical hits either four times the entry, in this case 3.60, or the combined iron condor drops in value to.10, then buy it back. If the trade is bought back at a loss, wait and set up the trade for the next month according to the entry rules. Remember, volatility often follows volatility, so don t be over eager to reenter. Some deviation from this exit is allowed, but if the spread is allowed to more than quintuple, when taking a loss, expectancy is hindered. 30

31 Also, unless a trade goes significantly against the trader immediately, the trade could very well need to quintuple, or more, to reach a price of four times the entry. This idea greatly increases the odds of the trade winning, but emphasizes that a good entry is key. Our probability analysis suggests the odds of the price of an option spread quintupling is low, even more so when time has passed. But if the spread price does quintuple, the option spread value will probably keep growing, so be mindful of the low of the trade since entering. If a position is under pressure, and the trader believes a reversal is about to take place, they will be tempted to wait the position out. However tempting it may be, it 31

32 would probably be better to take the spread flat, and roll it out to keep gamma (the rate of the change in delta) in check. Once in a great while it is prudent to allow options to expire, but it is rare. Typically, we divide the number of days left before expiration into the value of the spread, and if the quotient drops below the desired theta (time decay) per day, the position is no longer worth holding. This ensures the most efficient use of risk and usually requires positions to be closed before expiration. 32

33 Adjustments Adjustments are double edge swords. Unless the trader has an edge in picking short term direction, we suggest not adjusting trades in general. However, there are times when exiting at a very clear support or resistance point is not advisable, and an adjustment to buy more time makes sense. There are many ways to adjust a trade, one technique is presented here. When looking to use an adjustment technique instead of an outright exit, the trade has to be adjusted well before the traditional price based exit of a quadrupling of the entry of one of the vertical spreads. 33

34 One adjustment technique is to wait until one vertical spread increases to 2.5 times the entry. At this time the entire iron condor is purchased back. Then, a new iron condor is established using options which expire further out, and are sold for a slightly higher credit than the debit to close the original iron condor. The vertical call and put spreads are reset at nearly equal prices with the hope of the market stabilizing. This will very often work, but if the market continues to move directionally, or snap back, there will likely be slightly larger loss taken. Running through adjustment scenarios is a great exercise. Just use great care in putting them to work as they nearly always complicate the strategy. 34

35 Calculating Expectancy. Average winning month = / 2000 = 8.5% Average losing month = / 2000 = 9.5% Win Rate =.75 Loss Rate =.25 Expectancy = (.75 x 170 = ) (.25 x 190 = 47.50) = $80 per combined call and put spread (iron condor). $80 / 2000 = 4% per month average. 4% per month compounded is well over 50% per year. 4% a month is an average, but the equity curve will not be smooth as it will experience winning and losing months, multiple losing months are very possible. A 35

36 strategy such as this needs a minimum of 12 months for statistical tendencies to materialize. These numbers presented are raw and do not include transaction costs. Short term expectancy is probably higher; some positions will be shut down early at a smaller loss or even a small gain. There will be larger losses due to gaps and trading errors, long term expectancy could be lower as a whole as the likelihood of a rare event becomes higher. By pulling in the short strikes slightly closer to at the money (current market price) the average trade profit and loss will increase. For smaller returns and lower risk, push the short strikes out further. 36

37 The major criticism about the deep out of the money (strike prices far away from the current market) iron condor is the large loss which can be incurred with a rare, but enormous, move in the market. If the short strike goes at the money, the spread will, on average, be worth about 10 points. Even if two points were collected for the position, that is a risk reward of 5:1. The mathematical max risk for the trade is 10:1. The trader simply cannot allow these trades to get away from themselves, especially with the short vega trade structure. If the exit price is hit, exit early and move on. At the end of this report a modified iron condor method is described transforming this trade from short vega to 37

38 long vega, offers a better absolute risk:reward, and still maintains a short theta posture. 38

39 When Not to Sell With the entry and exit rules in place, we may want to explore when not to sell options. Evaluating market environments is notoriously difficult to do. We have developed different ways of measuring the behavior of markets, and, how accurate implied volatility readings may be at predicting future movements of the underlying. What we have found is, over the long term, and by averaging the number of excursion violations as measured by our criteria, implied volatilities are largely accurate. 39

40 For example, when selling an options one standard deviation out, with 30 calendar days left until expiration, the underlying will hit the strike price before expiration an average of 16% of the time. If naked strangles were to be written, with call and put strikes one standard deviation out, over the long term, one of the sides would be violated, before expiration, 32% of the time. Coincidentally, there will not be an excursion violation 68% of the time, which represents a 1 standard deviation figure. However, there are a select few years in the U.S. equity markets when the trend is so relentless, often to the upside, that the occurrence of a pre-expiration excursion violation was in excess of 50%. These are the times you simply have to get out of the way of the train. 40

41 A vertical spread on its own can have positive expectancy, but it is usually on the put side due to skew. Short calls are fairly well priced but they can often be exited early for a gain when given the opportunity. A way to mathematically define when not to sell premium is difficult to develop. From using historically low VIX levels to attempt predicting sell-offs, to using a price regurgitating trend indicator when trying to stay on the right side of the market, systematically predicting when to avoid selling options to steer clear of dangerous waters is challenging to accomplish. Many say to simply buy cheap volatility and sell expensive volatility. However, volatility trends can clearly continue much further than anticipated. 41

42 42

43 The Slope Indicator Through continued collaborative efforts, we have developed a proprietary indicator which measures the steepness, or slope, of a market relative to implied volatility. We simply refer to it as the slope indicator. In short, this indicator attempts to define when the market is more prone to committing an excursion violation. It defines when the market is trending more than implied volatilities are predicting it will. With a high enough reading we will buy back month strangles with small size and sit on our hands. 43

44 The formula is proprietary, but it is available to use for free at our site: My talented webmaster has constructed an interface to view the indicator over any daily time frame desired, beginning in Using the Slope indicator is simple. A reading under 6 is usually a market environment conducive to option selling. A reading of 6 to 6.5 indicates some moderate volatility, sell options carefully. With a reading over 6.5 we would be very hesitant to enter new positions. With readings over 7, we re usually buying back month strangles with small size. Once the strangle becomes 44

45 front month, and our exit price has not been hit, which is 5 times the entry price of one leg, we are unwinding the position. No need to be on the wrong side of accelerated theta. The Slope Indicator is not flawless, but if there is a prolonged imbalance of trendiness, it will keep us from selling options. In 2008, we saw some of the largest, and 45

46 most well known, premium sellers experience severe drawdowns in excess of 50%, in very short time frames. Some of the losses were due in part to reentering positions too quickly when the worst of the volatility was not over. Revenge trading has been the downfall of many a short options trader. 46

47 Summary The iron condor options system presented is a viable means for a trader to have a system with clearly defined entries and exits. Although different strategies may be better suited in different market environments by an experienced trader, this system can get the trader well on their way. trades the GTS Method of the iron condor for autotrade subscribers. Some discussion on that method follows. 47

48 GTS Method The GTS Method is a way to establish a position with an expiration graph very similar to an iron condor and yet be long vega on the put side, have the potential for windfall profits in a crash scenario, and still maintain the positive theta posture. The risk graph at initiation looks similar to this. 48

49 Although the trade structure continues to utilize 20 points spreads on the SPXPM, the trade structure is slightly modified. The trade is long vega on the put side which is a tremendous advantage over the long term. Below is the represented risk graph with an 11% increase in volatility. 49

50 Here is another look with the graph expanded. As can be seen, a market crash could actually be fortuitous. 50

51 The emphasis of being long vega is placed on the put side as an implied volatility explosion will most assuredly take place with a large move down. With a spike in the VIX of more than 20 points or more, the vega response is even more pronounced. The GTS Method is a way to sell option premium while still having protective positions at the wings. The put 51

52 vertical spread is converted to long vega with the potential for a benefit from a crash. The call vertical spread uses the reverse skew of calls against itself. Short call spreads are notorious for their drawback of accelerating gamma with a smaller spike up in the markets. The GTS Method takes much of the bite out of those relentless moves up in the market, especially at trade initiation. The other major piece of the GTS method is diversification of the model itself. Instead of trading the model on a single stock, the model is traded on an index. This eliminates company specific risk and allows the underlying to be more statistically viable. One top of using an index as the underlying, the model is split into 2 to 3 positions on the index where the trades entreies and 52

53 exits are staggered. This enables a shift in the market environment to be accommodated. This theory can also be applied to all iron condor traders as well. 53

54 Conclusion There are no secret option positions out there, just different ways of constructing risk graphs with known tools. The iron condor position laid out in this report is a great way for a trader to begin trading with a high win% strategy. The pace of the trade is also low with decreased gamma levels, allowing a trader more time to evaluate necessary adjustments. If iron condors are utilized, make sure the entry credit is adequate, and honor those stops. High probability iron condors very often take care of themselves. The GTS Method is a unique way of maintaining a positive theta stance for the iron condor and defend 54

55 against the potential pitfalls of both put and call vertical spreads. The GTS Method can be autotraded hands free with our affiliated brokers. For more information please visit Good trading. 55