Trading System Design. The Option Selling Model

Transcription

1 Trading System Design The Option Selling Model And Other Trading System Analysis J. Murakami 1

2 Headings 1. Introduction 2. The Debate 3. Objective 4. Markets 5. Trade Structure 6. Technology 7. Entry 8. Exit 9. Calculating Expectancy 10. When not to sell 11. The Slope Indicator 12. Conclusion 2

3 RISK STATEMENT: The trading of stocks, futures, commodities, index futures or any other securities has potential rewards, and it also has potential risks involved. Trading may not be suitable for all users of this Website and book. Anyone wishing to invest should seek his or her own independent financial or professional advice. The Information, Forms and other resources available on or through this Website and Book and received from or through this Website and Book such as s and/or newsletters are provided for education and informational purposes only, without any express or implied warranty of any kind, including warranties of accuracy, completeness, or fitness for any particular purpose. The Information contained in or provided from or through this Website and Book is not intended to be and does not constitute financial advice, investment advice, trading advice or any other advice. The Information on this Website and Book and provided from or through this Website and Book in the form of s and/or newsletters is general in nature and is not specific to the User or anyone else. USER SHOULD NOT MAKE ANY DECISION, FINANCIAL, INVESTMENTS, TRADING OR OTHERWISE, BASED ON ANY OF THE INFORMATION PRESENTED ON, OR DELIVERED BY ANY OF THE PRODUCTS, SERVICES, INTERNET WEB SITES WITHOUT UNDERTAKING INDEPENDENT DUE DILIGENCE AND CONSULTATION WITH A COMPETENT FINANCIAL ADVISOR OR PROFESSIONAL BROKER. User agrees that any and all use of the Information and Website and Book which User chooses to utilize, is completely at User's own risk and without any recourse whatsoever to GoTradeSignals, its associates, subsidiaries, partners or content Providers. User understands that User is using any and all Information, Forms and other resources available on or through this Website and Book and received from or through this Website and Book such as s and/or newsletters AT USER'S OWN RISK. 3

4 Introduction Welcome to the Option Selling model. With this model you, the trader, will be able to do what many successful traders are already doing. It may not be 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 writing is probably best for the novice options trader. While the greeks are not 4

5 referred to a great deal, there is 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 easy read for you too. And, this is a very easy read. If you need a primer, drop us a line, pinvestments@hotmail.com. This trading technique, as presented, takes as little as $700 to implement. Yes, there are ways to trade with even less. It might be suggested one use at least 5 contracts to mitigate the impact of commissions when using this system on the SPY. In our 5

6 examples, we will trade 5 contracts at a time. This increases margin requirements to approximately $3500 to get started with this model. The target profit potential per month is approximately 5.5% on margin before transaction costs. Margin rates vary, as well as commissions but you already knew that. 5.5% compounded for a year is nearly 100%. But, winning every month is difficult to do, so be prepared to take some losses. 6

7 The Debate Option selling vs. buying can often be a volatile debate. For the author, the debate is 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. If one is an objective individual, both sides of the discussion can be seen. But in the end, the trader has to make a choice. The parallels between the options business and the insurance business are numerous. Option sellers are essentially selling 7

8 insurance. Insurance companies, as a whole, can do very well. If the 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. 8

9 The question, then, can possibly be reduced to 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. 9

10 Objective The objective of this book is to introduce a systematic options selling model, which can be used by a common trader, with a common understanding of options, on a U.S. equity index, or a derivative thereof. A brief note on system traders, I would like to say affectionately, we re an interesting bunch. On average, we re very methodical and analytical, often isolated due to our trading style, and hard working. Many of us are hardwired to feel more comfortable 10

11 trading with quantified rules, but we ll keep trying to loosen up. Discretionary traders are probably less enthused by systematic rules, and they might be better suited viewing the system as a guideline. As with the last book, this one will be short, even shorter actually. Probably a good thing, considering my writing abilities. The information here is far from exhaustive. There are some great books out there, with much more advanced concepts and definitions, and are truly enjoyable to read. 11

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13 Markets The underlying instrument used in this book is the ticker SPY. However, other instruments can be used, such as the ES, SPX and others, but the trade structure will be slightly different. Commissions incurred using the SPY will likely be higher but the bid/ask spreads are typically narrower than the SPX. I m somewhat averse to pit traded markets in general, because it can often take a long while to get a fill, and many of those fills 13

14 have been unfairly poor in my experience. There are times, however, when pit traded contracts are more than viable and are the best vehicle to use. For years I used the CME SP pit, and the SPX is also pit traded. Many think the electronic markets are actually improving spreads and liquidity in all markets. A benefit of using the ES is the availability of End of Month options. This potentially offers 24 expiration opportunities a year, instead of the normal 12. ES EOM options do have wider bid/ask spreads with less liquidity but they are viable. ES options are also 14

15 electronically traded and available nearly 24/7. ES weekly options for week 1 and week 2 are also available, albeit with low volumes and open interest, but obtaining data for them can be challenging as some of the vendors are still working to avail the data. The SPY and SPX both have End of Month options available during the serial months (quarterlies) so this enables 16 expiration periods. The SPX also has weekly expirations and the volume and open interest is growing quickly. Options with less than a week of life left have theta amounts of nearly violent 15

16 proportions. If weekly options are viable, it would offer 52 expirations per year. The trade off in selling weekly options would most likely be the reduced cushion from a six sigma market event. 16

17 Trade Structure With regard to this system, in terms of making an attractive absolute return in equity markets, vertical spreads need to be used. This option selling model uses vertical spreads because the margin requirements for uncovered option selling in equity markets is substantial. Many traders simply call using spreads a bribing of the margin deities. However, uncovered, or naked, option selling can be utilized using the lower margin requirements of futures markets, as in the ES 17

18 and SP. Selling uncovered premium is the most efficient way to produce a credit, and the most risky, in terms of theoretical max loss, and vega exposure. 18

19 A vertical spread is established by buying and selling different strike prices in the same month and underlying. It is often used as a risk management tool. Uncovered option selling is usually considered more risky than selling premium via vertical spreads, and most spreads in general, although covered calls, a strategy accepted fairly well, has a very similar risk profile to a written uncovered put option. Again, this system uses vertical spreads. Either way, if leverage is used, positions need to be taken seriously. 19

20 Technology There are some great trading platforms available to the independent trader, many for free. There are also a number of charting websites which stream at no charge. For quick charts on the fly, I have used for over a decade. Some of the images in this book are from Bigcharts, and I want to thank them for their content. Drop me an , I d be happy steer you in a direction for website tools, or trading 20

21 platforms etc, if I can. If you have a great tool, I would like to hear about it as well. 21

22 Entry The put entry does not use probability analysis, or a multiplier of the standard deviation, to choose the short strike price. This 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 put vertical spread with days left before expiration. Every once in a while, a put can be written with less than 30 days left before expiration. But, because U.S. equity markets tend to fall 22

23 significantly faster than they rise, it is not advisable. When trading in this fashion, the trader does not want the underlying anywhere near their strike price. Gamma (rate at which an option will increase) will simply grow too rapidly with a severe market drop. One associate on a popular forum referred to this as gamma gearing. Pull up an option chain on the SPY and find the put with a value of at least.50, usually about two standard deviations away. An option chain can be found at but they are not streaming option chains. If possible, find a 23

24 streaming option chain. The short put is usually sold for about.50 and the long put is usually bought for about.25. The minimum points the spread should be sold for is.25 and not for more than.30. There are usually 7 to 8 strikes between the puts in the vertical spread. The call entry uses a similar concept. Eligible calls have days until expiration. Typically, the trader is looking for a 3 to 5 point call spread with a credit of no less than.25 and no more than

25 For the beginners, 1 options contract controls 100 SPY shares. So if we sell one option share for.25, we multiply it by 100 for the contract value, which is $25. When trading 5 contracts at a time, we multiply $25 by 5 for a product of $

26 Here is how the numbers line up trading 5 contracts: Vertical Put Spread credit =.25 Vertical Call Spread credit = x 5 contracts (puts) = $ x 5 contracts (calls) = $125 Total premium = $250 $250 / $3500 (premium / margin) = 7% 26

27 Exit The exit for the vertical spread is also price based. If the vertical hits either 3 times the entry, in this case.75, or drops in value to.05 or less, then buy it back. If a 5 contract vertical spread is sold to open for.25, and bought to close for.05, the winning trade has a $100 profit (500 x.20). Conversely, if the same trade is bought back for.75, the losing trade has a $250 loss (500 x.50). Since there is a call and put vertical spread on, and only one side can lose at a time, the average winning month is $

28 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 the market. But, it will sometimes be tempting. Some deviation from this exit is allowed, but if the spread is allowed to more than triple when taking a loss, expectancy is greatly hindered. Also, unless a trade goes significantly against the trader immediately, the trade could very well need to quadruple, or quintuple, to reach a price of three times 28

29 the entry. This idea greatly increases the odds of winning, but a good entry is key. Our probability analysis suggests the odds of an option quintupling is fairly low. And if it does quintuple, the trade will probably keep going against the trader, 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, and if the trader must reenter, it would probably be better to take the spread flat, and roll it out 29

30 to keep gamma (the rate of the change in delta) in check. One of the few times to deviate from the exit technique is if there is significant long term support or resistance backing up the position. Markets have an uncanny knack of gunning for those nice round numbers, and then reversing. Once in a great while, we will allow options to expire, but it is rare. Typically, I divide the number of days left before expiration into the value of the spread, and if it drops below the desired theta (time decay expressed in 30

31 dollars) per day, the position is no longer worth holding. This ensures the most efficient use of capital and usually requires positions to be closed before expiration. If the position is not ready to close, the market is closing in on the position, and gamma is most likely higher than I would like. 31

32 Calculating Expectancy Average winning month = / 3500 = 5.7% Average losing month = / 3500 = 7.1% Win Rate =.80 Loss Rate =.20 Expectancy =.80 x x 250 = $110 per combined call and put spread (condor) $110 / 3500 = 3% per month average. 3% per month compounded is 42% per year. 32

33 Minus transaction costs, of course. Short term expectancy is probably higher; some positions will be shut down at a smaller loss or even a gain. There will be larger losses due to gaps and trading errors, long term expectancy could be lower. By pulling the short strikes closer to at the money (options at current market price) the average trade and risk will increase. For smaller returns and lower risk, push the short strikes out further. 33

34 When Not to Sell With the entry and exit rules in place, we may want to explore when not to sell options. Evaluating and quantifying market environments is notoriously difficult to do. By collaborating with some very talented traders, 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. 34

35 What we found was, over the long term, and by averaging the number of excursion violations as measured by our criteria, implied volatilities, which are, in short, what the market is predicting the future range will be, are pretty accurate. For example, when selling an option 1 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 a naked strangle were to be written, with call and put strikes 1 standard deviation out, over the long term, one of the sides would be violated, before 35

36 expiration, 32% of the time. Coincidentally, there will not be an excursion violation 68% of the time, which represents our 1 standard deviation figure. The numbers line up. However, there are some 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. A vertical spread, on its own, has positive expectancy, but it is more pronounced on the put side, due to skew, which in this case is the relatively high prices 36

37 of puts. Stand along vertical call spreads do very well sideways and bear markets. A way to mathematically define when not to sell premium is difficult to develop. From using historically low VIX levels to try and predict sell-offs, to using a price regurgitating trend indicator to stay on the right side of the market, systematically predicting when to avoid selling options, and steer clear of dangerous waters, is challenging to accomplish. 37

38 The Slope Indicator Through continued collaborative efforts, we have developed a proprietary indicator which measures the steepness, or slope, of a market. We re so creative, we decided to call it the Slope Indicator, only because steepness is harder to say, with more than one syllable and all. 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 38

39 implied volatilities are predicting it will. With a high enough reading we will buy backmonth strangles with small size and sit on our hands. As the formula is proprietary, I put it in my temporary memory bank so I cannot be tortured for it. At this time, however, 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

40 Using it 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 I 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 front month, and my exit price has not been hit, which is 5 times the entry price of one leg, I m unwinding the position. No need to be on the wrong side of theta. 40

41 In terms of the SPY, we are using short vertical spreads, albeit large ones. But, there is still some reduction in vega exposure (risk of loss due to implied volatility increasing). The VIX and VXO are implied volatility indices. With a back month long strangle on, 41

42 vega exposure is reduced even more. Sometimes having long exposure comes in very handy. The Slope Indicator is not perfect, 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 most well known, premium sellers experience severe drawdowns. Some 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. 42

43 Conclusion Presented was an options system with clearly defined entries and exits. Clearly, different strategies can be employed in different market environments by an experienced trader, but this system can get the trader started. If you have any questions, feel free to drop us a line. Good trading to you. RISK STATEMENT: The trading of stocks, futures, commodities, index futures or any other securities has potential rewards, and it also has potential risks involved. Trading may not be suitable for all users of this Website and book. Anyone wishing to invest should seek his or her own independent financial or professional advice. The Information, Forms and other resources available on or through this Website and Book and received from or through this Website and Book such as s and/or newsletters are provided for education and informational purposes only, without any express or implied warranty of any kind, including warranties of accuracy, completeness, or fitness for any particular purpose. The Information contained in or provided from or through this Website and Book is not intended to be and does not constitute 43

44 financial advice, investment advice, trading advice or any other advice. The Information on this Website and Book and provided from or through this Website and Book in the form of s and/or newsletters is general in nature and is not specific to the User or anyone else. USER SHOULD NOT MAKE ANY DECISION, FINANCIAL, INVESTMENTS, TRADING OR OTHERWISE, BASED ON ANY OF THE INFORMATION PRESENTED ON, OR DELIVERED BY ANY OF THE PRODUCTS, SERVICES, INTERNET WEB SITES WITHOUT UNDERTAKING INDEPENDENT DUE DILIGENCE AND CONSULTATION WITH A COMPETENT FINANCIAL ADVISOR OR PROFESSIONAL BROKER. User agrees that any and all use of the Information and Website and Book which User chooses to utilize, is completely at User's own risk and without any recourse whatsoever to GoTradeSignals, its associates, subsidiaries, partners or content Providers. User understands that User is using any and all Information, Forms and other resources available on or through this Website and Book and received from or through this Website and Book such as s and/or newsletters AT USER'S OWN RISK. 44