An update to the articles: Spread Betting and Trading Naked Options Mike Newman Writing FTSE100 index options can be a very profitable trading method, providing the underlying, in this case the FTSE100 index, remains within the boundaries of the break-even points of your written and/or modified strategies. My Different Trading Style Whilst all of what I said in my two earlier articles on Options trading remain true and the spread betters continue to provide me with totally free money AND they pay me interest on the profits I make with their free money (when banks return to paying interest!) and that lovely Gordon Brown continues to avoid taxing me on my trading profits, my FTSE100 Index options trading style has changed slightly since June 2006. My revised trading still enables me to take my living expenses out of my options trading profits as I have done for the last 9 years, but the wilder swings of high wins and overall lower, but still annoying losses, have been replaced by a calmer, less stressful profit and occasional loss experiences see later. The previous articles referred to my trading method of opening straddles by writing or selling both puts and calls for the same month and at the same strike price about two months out from expiry and moving the strategy up and down as the market moved starting off with an at the money (ATM) straddle as per the red straddle in the example below. Straddle writing remains a potentially extremely profitable strategy with annual gains of over 100% being common, but the width of the break-even points is always narrower, and therefore the potential risk is higher than strategies that start off as a wider strangle - writing, lower puts and higher calls for the same month as in the green example below. What may also be a disadvantage of straddle writing is that the margin required by the broker will be higher than for a strangle and this margin requirement will increase more quickly as the underlying moves towards one side or the other, possibly resulting in a greater tendency or need to trade earlier as the underlying moves towards one of the break-even points. I moved to opening with wider strangles from June 2006, accepting a lower maximum gain for less frequent trading and these trades require less margin and generally provide more frequent profitable months except October 2008 of which more later. The above graph example shows that the pointed straddle (red) obviously gives a much larger potential gain than the flat top strangle (green) - its a bit like the hare and the tortoise, the more risky straddle is more at risk to larger moves than the plodding strangle and it requires more attention to avoid a potential loss. The straddle may need to be moved more often, generally by selling more puts or calls at different strikes and as mentioned, it requires more margin, especially when one side is in the money (ITM), i.e. if the index went to 6000 in the above example, the sold 6100 puts in the straddle above would be ITM by 100 points, whereas in the above example, the wider strangle would not go ITM until the index fell to 5525 or rose to 6525. The change that I have made from straddles to strangles, requires less attention to market moves, lower margin requirements and less modifications during the life of the strangle, which to me are all worth the sacrifice of often spectacular profits in favour of regular but lower profits with less associated hassle and stress. What I did was simply to stop looking at the high monthly profits I had been making most months, but with a few occasional sharp stressful losses, and to ask myself what percentage return I would require to cover my living expenses and to have enough left over to increase my options trading capital on a monthly basis. This would smooth out the high peaks and occasional low troughs of my previous trading whilst trading in a less stressful way. Copyright: M D Newman. Issued: 30 th August 2009 1
The First Flush of Success! Since June 2006 I have been writing (selling) wide strangles about two months from expiry, taking in sufficient premium to generally exceed my financial objective. Since June 06 my revised safer trading has given me a conservative 30% annualised gain to October 2008 as shown below when I first prepared this update last year with hindsight I obviously spoke too soon! (see later). 200% FTSE 100 Strangle Gain From June 2006 150% 100% 50% 0% June 06 Jul Aug Sep Oct Nov Dec Jan 07 Feb Mar Apr May June Jul Aug Sep Oct Nov Dec Jan 08 Feb Mar Apr May June July Aug Note that the dips and sideways movements in my trading graph above are followed by larger upward blips a month or two later. These are due to me profitably rolling contracts into later months. So the August to September 07 falls were surpassed by the October to December and March gains. The volatility of the markets has also assisted me by increasing the contract premiums that in turn has enabled me to open my contracts much wider - around 1000 points wide - and still achieve my required return. On several occasions I have also been able to add Copyright: M D Newman. Issued: 30 th August 2009 2
to an open strangle with additional calls and or puts as the index has moved up or down without, or hardly, compromising on the wide break-even of my initial position. I have been trading this style since June 2006 and I have retained or controlled all my trading profits every month to September 2008 and from November 2008 to now. My trading during the 900 point drop and recovery from 12 th July 2007 to 15 th October 2007 needs an explanation. To avoid the possibility of a potential loss of some of my August and September profits, I rolled my puts out and down to December 2007 and to March 2008. What I did was to close my potentially loss making puts shortly before August expiry (expiry is on the 3 rd Friday of every month) and at the same time, I sold December and March puts much lower down for slightly more premium. If the index had continued to fall then I should have been able to do the same again, close my open puts and write some more puts further out and lower down for the same or higher premium. Some will say that I took a loss on closing my puts in August and that as future profits of the moved puts were not guaranteed (i.e. the index could fall even further), a loss was a loss. Technically they are right of course, as my profits graph for the period shows, but the roll out and down that I did was not like a share trading decision where a share that you hold falls in price to a level where you sell it at a loss and then have to try to recover the loss by buying some other share in the hope that it will rise and recover your losses. By selling options for a later month at the same time as closing the near month option(s) (known as rolling) and for the same or higher premium, you gain from the higher premiums being offered at the time, and as the underlying moves towards your previous break-even you ensure that the profit you have given up by buying back your contract is released to you in the later month providing you don t have to roll again, in which case a second roll may be required to yet again delay your profit for yet another period. This rolling generally ensures that your initial profit is eventually retained, which is a process just not available to any share or Trust purchase investment. As an example, say you wrote an OTM (out of the money i.e. several hundred points lower than where the FTSE100 index is now) put for 50p. Some time later the index has fallen and you think the fall will continue below your break-even point and so you close it for say 100p. Technically you have lost 500 on that contract. But if you write another put, hopefully lower down, for a later month for say 105p then your initial anticipated profit of 500 could become 550, albeit a month or two later than your intended initial 500 profit, providing your lower strike price is not below the eventual expiry value. On 17 th August 2007, options expiry day, the FTSE100 index had fallen 900 points and was at its lowest point, (and with hindsight, it recovered all of the 900 points at the same speed). I moved my break-even point down from 5805 in September to 5334 in December and 5053 in March 2008. In my mind this was like transferring some of my August and September profits to later months by rolling my puts out and down for a slightly greater profit - i.e. to defer my profits to later months and at lower levels where profits were more likely to be retained. To me this is far more certain to finalise in a profit than the share example above. This controlled moved avoided any loss over the combined period and still enabled me to trade profitably in the intervening and following months. With hindsight of course I should not have rolled out my September puts at all since the low of the FTSE100 index, which was exactly on the day of the August expiry, recovered enough of its losses by September expiry so that it was higher than my September put strike price and so I could have kept all my September profits in the month of September - but by rolling I knew my new positions were more likely to remain profitable and my stress levels would remain negligible. Volatility There is one concern over my new trading method that I shall have to watch out for and that is volatility. What this means is that when the volatility is high I can open wider strangles for the same premium when the volatility is low, which in a way means I have less risk when the volatility is high and more risk than when volatility is low. Consider the three following graphs. The thinner line approximately drawn from top right to bottom left represents the average premium, taken over 20 plus years, for a put and a call at the same strike price closest to the where the FTSE100 index is on the same day (i.e. say 20 days to expiry) of writing it, known as the ATM [At The Money] premium. This line always finishes at zero (bottom left) at expiry. The thicker line represents the ATM premium for a straddle written Copyright: M D Newman. Issued: 30 th August 2009 3
for the month in question. So if the thicker line is above the thinner line, premiums and therefore volatility are higher than normal and if the thicker line is below the thinner line, premiums and volatility are below average. In the examples below, for most of the time between 2003 and 2006 volatility and premiums were below average. Therefore there is potentially more risk of the index moving one way or the other outside the break even points because with low volatility/premiums, the break-even width is less. This below average volatility/premium is shown in the first graph. But between then (April 2005) and now the volatility/premium has virtually always been higher than average as shown in the second graph. More recently volatility/premiums have dropped a long way towards and even below the average, suggesting that, in this case, the premium for writing an August 09 strangle (or straddle), 50 days and less from expiry is less than for the average over the last 20 or so years surprising given the substantial market moves over the last couple of years. Copyright: M D Newman. Issued: 30 th August 2009 4
If the volatility and premiums continue to fall, as in the third graph above, and return to the below average levels of the first graph, I will consider writing more wide puts and calls at lower than previous premiums to ensure I continue to achieve my desired monthly returns. Whilst that may appear to be more risky, some say that lower volatility is a sign of greater market stability, which should offset my increasing volume of calls and puts. 10 th October An Unprecedented Experience As a precursor to my performance, consider the two graphs below which show the extraordinarily event of that dreadful day (for me), Friday 10 th October 2008 The first shows the high premiums/premiums for a November 2008 FTSE100 contract on 10 th October where the thick line of an ATM straddle has gone stratospheric. Several world famous financial experts later made comments that it was the worst market day for the last 100 years and that the world s financial markets had been on the brink of total collapse at that time. Some might say that it was Warren Buffett with his immediate cash injection of $5bn into Goldman Sachs, which probably avoided GS, and many more high profile banks going the same way as Lehman Brothers eight days earlier. If GS, and therefore many others had collapsed then who knows where the world economies would be now. Copyright: M D Newman. Issued: 30 th August 2009 5
The good news of course in hindsight, and as mentioned earlier, this blue time decay line in the above graph in this example had to drop to zero at expiry in 30 trading days time, so the focused options trader (not me at the time) could have made a substantial profit in those 30 days. But for me closing out on 10 th October was excessively expensive. I did so because it seemed that the dramatic fall would continue for some time and my rapidly increasing margin requirement could not support much more grief and so I closed my loosing puts at an excessive cost. With hindsight of course, even if I had avoided closing until near the end of the day, the cost would have been quite a bit lower and by 14 th October a lot lower as the FTSE100 had reversed its decline (for a few days) by then and a lot of the volatility had reduced... but s they say, hindsight is a wonderful thing! As a further example of the stress that the UK stock market was under at that time (let alone other financial markets) and to put my performance into context, take a look at the following graph which, like the exceptional volatility graph above, shows shares in the UK All Share Index that had reached a one year high or low each day since April 2004. The worst day by a mile was, coincidentally, 10 th October 2008. 900 800 HIGHS LOWS 700 600 500 400 300 200 100 0 02/04/2009 02/01/2009 02/10/2008 02/07/2008 02/04/2008 02/01/2008 02/10/2007 02/07/2007 02/04/2007 02/01/2007 02/10/2006 02/07/2006 02/04/2006 02/01/2006 02/10/2005 02/07/2005 02/04/2005 02/01/2005 02/10/2004 02/07/2004 02/04/2004 My Performance The spikes in the two graphs above and the once in a lifetime events give little comfort to my loss other than to highlight that others must have been as badly affected. Given the events of 10 th October and that I still had some short October and November puts, I was faced with having to roll my deep ITM, mainly November 08 puts. But, and I ve never experienced it before or since. The unprecedented market action shown in the above two slides severely affected the options prices so that I couldn t roll down to even where the FTSE100 was at the time since the premium offered to put writers was so low whilst brokers were required to hold increasingly higher margins against a likely further substantial market drop. All I felt confident in doing was to close my positions at a substantial loss and to start again after a few days when some market sense had returned. Whilst this paragraph may put off new options traders, I believe the comments by market experts, that such unprecedented market and premium action was a once in a lifetime event, suggest that is event will act as a reminder of what did happen rather than what is likely to happen in the future. Hopefully new options traders should be able to learn from the recent past whilst such a dramatic experience is unlikely to happen for a long time if at all. It is also worth noting that other FTSE100 index options traders did not suffer my fate and were profitable in October 2008 and adjacent months. Repairing the damage to my performance (and my capital) post October 2008 is shown in the graph below. Perhaps I should be pleased that every index that I have looked at is still at a loss from June 2008 to now and that having survived the worst (yet) ravages of the Stock Market over the last three years my 100% gain (to July 2009) is better than the majority of expert fund managers and that hopefully I should be able to avoid the dole queue for a while longer. Copyright: M D Newman. Issued: 30 th August 2009 6
Whilst this article is written at the end of July 2009, I have shown my profit in the graph below out to September 2009, with an encouraging future positive jump in August, which is as a result of rolling some contracts over the last 3 months. So the dips in May and June should be (fingers crossed) more than compensated for by a successful expiry mid August. Astute options traders may question why I had to roll recently when the FTSE100 has been reasonably gentle over the last 3 months. The reason is that as well as trading FTSE100 Index options I have over the last few months been occasionally trading options in oil and a little bit in currencies. It is the former that has caused me to roll several times. Whilst a couple of months ago it seemed obvious that the world would require less oil as we are told economies are still on their knees, jobless numbers are still rising, oil stock piles were at all time highs and the large user of oil at this time, the American driving season when just about everybody in the USA drives long distances for holiday activities, would be more subdued this year, oil kept on going up, which caused me to have to roll several times. I now feel comfortable that my puts as low as $40 and my calls as high as 80$ should at last expire worthless in mid August and so I ve included those profits in the graph as well as my current open September FTSE100 options which may or may not require attention before expiry. 200% FTSE 100 Strangle Gain Jun 06 to Sep 09 150% 100% 50% 0% Jun 06 Jan 07 Jan 08 Jan 09 Jun Sep Conclusion Hopefully this update will encourage more investors to trade options which in my view remains a controllable (apart from one day), safer and a more reliable 3 way bet compared to the one way betting of share trading. If you buy shares which of the many thousands are you going to choose? - Then the only way of making a profit is if the share price rises or if the dividends more than offset any share price fall. Bear in mind that the complexities of choosing what shares to buy and the monitoring of them is way more time consuming and difficult than trading Options. With Index or sector Options you are looking at just one thing, that index and what is likely to drive it up or down. If you are a share buying fundamentalist then deciding what shares to buy out of a choice of thousands is mind boggling and you are unlikely to be on a level playing field since much of the information you use to make your buying and for that matter selling decisions is out of date and often not reported. If you rely on graphs and technical analysis then having sieved thousands of shares, are you sure you have used the best sieve and of the few left from which to make your selection(s) can you pick the best and do you have time to constantly monitor them to avoid a sudden collapse to both the share price and to your capital? Copyright: M D Newman. Issued: 30 th August 2009 7
Index Options are simpler to follow, will not disappear like some high profile shares and will always enable you to range trade and to be profitable no matter if the price of the underlying rises, falls or stays still. To my way of thinking, options trading is and remains the obvious choice for the majority of my investment portfolio. Copyright: M D Newman. Issued: 30 th August 2009 8