Trade Plan for Option Volatility Spreading

Trade Plan for Option Volatility Spreading 1

Table of Contents I Overview:...3 Performance:...3 Strategy:...3 What to trade:...3 When to trade:...3 Where to trade:...4 How to trade:...4 Rules to buy:...4 Rules to sell:...4 II - Sensitivities:...5 Delta:...5 Vega:...5 Theta:...5 Gamma:...5 Rho:...6 III - Expiration:...6 American versus European:...6 IB automatic liquidation based on post-expiration exposure:...6 IV - Explanation Of Methodology:...7 Step 1 - analyze volatility:...7 Step 2 - start Trade Finder:...8 Step 3 specify the Targets in Trade Finder:...9 Step 4 specify the Strategies in Trade Finder:...10 Step 5 set the Goals in Trade Finder:...11 Step 6 - select the Filters in Trade Finder:...12 Step 7 - evaluate the search output from Trade Finder:...13 Step 8 analyze the recommended trade(s) from Trade Finder:...14 Step 9 modify the trade sizes and analyze the trade again...15 Step 10 - put trade(s) on & monitor the portfolio using IB Risk Navigator:...16 2

I Overview: Performance: Real-money institutional sub-account at Interactive Brokers generated over a 10% return in equity option trading profits from October 12, 2012 through December 21, 2012 via volatility spreading. Trades are documented in separate spreadsheet showing a $765.71 profit after all commissions. Strategy: The trade plan is Delta-neutral option volatility spreading via the OptionVue 7.16+ platform using the Interactive Brokers (IB) Traders Workstation (TWS) 933.5. Specifically, we use the IB TWS Application Programming Interface (API) to continuously search for high probability option spreads via OptionVue. We also use the IB API connection to access the proprietary OptionVue VXX tools to analyze market implied volatilities in real time. Finally, we actively manage our IB portfolio using the proprietary TWS tools e.g. Risk Navigator, Options Analytics and Options Trader. What to trade: Option volatility spreads with clear pre-defined risk/reward ratios: backspreads, butterflies, calendars, condors, married calls, married puts, straddles, strangles & vertical spreads. In other words, we avoid uncovered strategies. All the underlyings must have deep liquidity e.g. SPX (S&P 500), XEO (S&P 100 European style execution) & OEX (S&P 100 American style execution). Options' bid/ask spreads must be tight e.g. AAPL (Apple), AMZN (Amazon), GOOG (Google) etc. When to trade: We trade during regular market hours from 09:30 16:00 EST. On expiration day we trade from 09:30 16:30 EST since IB must receive any expiration notice by 16:30 EST. We are at our desk by 07:00 EST. During this time we are running both IB/TWS/API and OptionVue to select both potential trades and trade modifications. Simultaneously, we are monitoring the pre-market open sessions (08:0009:30 EST) to track the behavior of the associated futures markets e.g. ES (S&P 500), NQ (Nasdaq 100) and YM (Dow 30) as well as any impact of bond yields on general market direction e.g. ZB (30 Year Bond) and ZN (10 Year Bond). Again, we are not necessarily picking trends--just trying to get a sense of how aggressively we might have to defend our positions during the upcoming session from a Gamma standpoint. We typically trade the weekly's and front two months--up to (and including through) expiration day. We trade deep liquid underlyings to help ensure tight bid/ask spreads on all the options comprising our volatility spreads. 3

Where to trade: We subscribe to the following data feeds via IB TWS: Chicago Board of Options Exchange (CBOE), Chicago Mercantile Exchange (CME) and NASDAQ (ARCA/Island). We track and trade option volatility spreads on the broad market indices e.g. XEO (S&P 100 European), OEX (S&P 100 American) and SPX (S&P 500). In addition, we track and trade option volatility spreads on the Exchange Traded Funds (ETFs) of broad market indices like DIA (Dow Jones Industrial Average), SPY (S&P 500) & QQQ (Nasdaq 100). Moreover, we also trade volatility spreads for key stocks comprising the broad market indices like AAPL (Apple), GOOG (Google) and INTC (Intel Corporation). Finally, we also trade volatility option spreads on individual commodity-based equities like APA (Apache Corporation) & GG (Goldcorp Inc.) etc. To recap, we trade options whose underlyings are deep and liquid; specifically, all our volatility trades must have tight i.e. narrow bid/ask spreads. How to trade: Rules to buy: (1) setup: implied volatility of the underlying is below the statistical volatility of the underlying; (2) check: underlying trading volume is both deep and liquid & options' bid/ask spreads are tight; and (3) trigger: the spreads theoretical (fair-value) price is temporarily below its actual market price. Note: if the fair-value price persists below the market price then either our notion of the theoretical price is wrong e.g. we used an incorrect model and/or market conditions have changed. At that point, we may have to either exit the position early and/or modify the original trade as appropriate. The question of either refining an existing position or exiting it entirely--is based on the output from the Interactive Brokers' Risk Navigator. Moreover, we consider any appropriate search results from the Trade Finder portion of OptionVue in deciding ether to exit or modify a particular position. Rules to sell: (1) setup: implied volatility of the underlying is above the statistical volatility of the underlying; (2) check: underlying trading volume is both deep and liquid & options' bid/ask spreads are tight; and (3) trigger: the spreads theoretical (fair-value) price is temporarily above its actual market price. Note: if the fair-value price persists above the market price then either our notion of the theoretical price is wrong e.g. we used an incorrect model and/or market conditions have changed. At that point, we may have to either exit the position early and/or modify the original trade as appropriate. The question of either refining an existing position or exiting it entirely--is based on the output from the Interactive Brokers' Risk Navigator. Moreover, we consider any appropriate search results from the Trade Finder portion of OptionVue in deciding ether to exit or modify a particular position. 4

II - Sensitivities: Delta: Irrespective of volatility--our overall position is typically as close as feasible to Delta-neutral i.e. zero overall Delta exposure. In other words, we may be directional in a particular underlying (depending on the risk/reward ratio) but our complete portfolios' net position is flat. For example, bullish spread in XEO (S&P 100 European) but also simultaneously bearish spread in SPX (S&P 500). At times, we may temporarily be not Delta neutral because we are legging into spreads. For example, Interactive Brokers does not let us input either a native iron condor spread order and/or a native iron butterfly spread order so we have to leg into these positions through the use of at least 2 separate orders using vertical spreads. Vega: When the implied volatility is much greater than the statistical volatility then we sell premium and are short Vega e.g. long butterflies, calendars, condors and vertical spreads. When the implied volatility is much less than the statistical volatility then we are net long Vega as the premium we usually sell is offset by our overall net long call and overall net long put positions. We put on these additional backspreads, straddles, strangles to take advantage of large price swings (in either direction) when market implied volatility is low. To be specific, we calculate each underlyings' historical volatility, each underlyings' statistical volatility and each option's (on the underlying) implied volatility. In addition, we track the markets' overall volatility using both the Chicago Board of Options Exchange (CBOE) VIX (Volatility Index) as well as the ipath S&P 500 VIX Short Term Futures ETN (VXX). Here ETN is defined as Exchange Traded Note. Theta: When the implied volatility is much greater than the statistical volatility then we sell premium and are long Theta e.g. butterflies, calendars, condors and vertical spreads. Recall Theta is negative for a long option position so when we sell the negative--we are long Theta i.e. minus a negative = positive. When the implied volatility is much less than the statistical volatility then we are flat premium as the premium we usually sell--is offset by our overall net long call and overall net long put position e.g. additional backspreads, straddles and strangles. Gamma: We track Gamma to ensure that the overall portfolio remains Delta-neutral irrespective of large price swings. Specifically, the Gamma of an option indicates how the Delta of an option will change relative 5

to a one point move in the underlying asset. In other words, the Gamma shows the option's Deltasensitivity to market price changes. We get a sense of how Gamma might behave by watching the following stock-index & bond futures: ES (S&P 500), NQ (Nasdaq 100), YM (Dow 30); ZB (30 year bond) and ZN (10 year bond). Rho: We track the Rho to measure the impact of interest rates on our portfolio. Specifically, Rho measures the rate at which the price of a derivative changes relative to a change in the risk-free rate of interest. In other words, Rho measures the sensitivity of an option to a change in interest rates. Currently, interest rates are low so Rho is relatively stable. Nevertheless, we get a sense of how Rho might impact our positions (in the upcoming trading session) by tracking the following bond yields: TYX (30 year bond yield), TNX (10 year bond yield) and FVX (5 year bond yield). In addition, we also track bond prices explicitly by monitoring the following bond futures: ZB (30 year bond) and ZN (10 year bond). III - Expiration: American versus European: We traded both American and European options but tend to favor European options due to the decreased risk of assignment. When we are exercised on either our short calls or short puts then we liquidated our short stock or long equity positions (as soon as possible) based on market conditions. We were executed on several options e.g. OEX (S&P 100 American), XEO (S&P 100 European), SPX (S&P 500) and XDS (Swiss Franc) options. In addition, we were actually assigned short stock on INTC (Intel Corporation) options when the call options we wrote were exercised. As previously mentioned, when we are executed on our options i.e. assigned either long and/or short stock we look to liquidate our underlying equity positions (as soon as feasible) taking into account the overall risk sensitivities of the entire portfolio. IB automatic liquidation based on post-expiration exposure: We actively manage our option positions especially on expiration days. After 1300 EST on expiration day--the IB risk management system may automatically liquidate any positions based on anticipated post-expiration exposure. This is why we favor equity indices via European expiration; although, we do trade American-style stock options when the risk/reward ratio is sufficient. 6

IV - Explanation Of Methodology: Step 1 - analyze volatility: We compare the implied volatility (IV) to the statistical volatility (SV). Next, we use the proprietary OptionVue Lentz Volatility Indicator (LVI) to determine whether the difference between IV and SV is large enough to actually put on a trade. Specifically, using the OptionVue proprietary VXX tools we check whether IV is high enough above SV to explicitly sell premium i.e. long Theta. Conversely, we use the proprietary OptionVue VXX tools to determine whether IV is low enough below the SV to be net long calls and/or net long puts i.e. flat Theta. VXX stands for ipath S&P 500 VIX Short Term Futures ETN. ETN stands for Exchange Traded Note. These are the volatility benchmarks we track. 7

Step 2 - start Trade Finder: We start the OptionVue Trade Finder by specifying the assets per screen shot listed below. Specifically, we start looking for trades based on selecting the underlying whose future volatility behavior is closest to what we expect to actually occur. In this case, it is the underlying whose volatilities we analyzed in step one i.e. the SPX or S&P 500. To recap, (for that instance) IV was sufficiently different from the SV to warrant additional consideration. In general, we are trading option spreads on broad market indices like NDX (Nasdaq 100), OEX (S&P 100 American-style) or XEO (S&P 100 European-style). In addition, we are also trading option spreads on the ETF's of broad market indices like SPY (S&P 500), DIA (Dow Jones Industrial Average) or QQQ (Nasdaq 100). To reiterate, the question of which particular option spread to place--can only be determined by first thoroughly analyzing each markets' volatilities. In other words, we begin by comparing the historical volatility to the statistical volatility and then the statistical volatility to the implied volatility of the underlyings' options. The bottom line is that we usually repeat step 1 (several times) for each of the markets that we are considering. Once we determine which particular underlying currently presents the best opportunity for the future of our portfolio--then we take that market as the input for step 2. 8

Step 3 specify the Targets in Trade Finder: Next we select the appropriate target type. There are three choices: Price, Price Range and Bell Curve. We choose one of the options based on our volatility analysis. Since our volatility analysis did not indicate a strong trend either way--we select Bell Curve this time--as we are expecting a normal price distribution. 9

Step 4 specify the Strategies in Trade Finder: Next, we select the strategies to search for. As previously mentioned, we are interested in covered option spreads. In other words, we are not interested in any uncovered option spreads. Typically, we usually trade backspreads, butterflies, condors, time spreads, straddles, strangles and vertical spreads. However, to get an overall sense of the options market--we also include the following types of covered strategies in our Trade Finder search: long option, married puts, long underlying, collar, diagonal debit spreads, short option (covered), short underlying, and covered write on cv (convertible) secs (securities). As previously mentioned, our search is generally on the weekly's and the front two months. This is done to maximize the chance of getting options with good liquidity i.e. high trading volume with tight bid/ask spreads. We do not generally include LEAPs. 10

Step 5 set the Goals in Trade Finder: Next, we specify our goals by choosing our comparison basis. There are three options: Profit/Loss, Yield and Ann. Yield i.e. Annualized Yield. We choose Profit/Loss because we are trading a small account. Next we choose our put call ratio for straddles, strangles and condors. There are two options Call/put ratio 1 to 1 and Call/put ratio delta neutral. We choose Call/put ratio 1 to 1. Finally, we select the ranking basis. There are 6 options: Expected return (E.R.), Worst case return (W.C.R.), Best case return (B.C.R.), Probability of profit, Ratio of B.C.R/W.C.R and Ratio of E.R/W.C.R. We choose Ratio of E.R./W.C.R as we have to be very sensitive to Interactive Brokers' post-expiration exposure monitoring software. As previously mentioned, IB may automatically liquidate options based on anticipated post-expiration exposure from their monitoring software. 11

Step 6 - select the Filters in Trade Finder: Next, we specify our Filters. For this particular search, we set the following Option Qualifiers: Only consider options expiring in 60 days or less ; Bid-Ask gap is less than or equal to 1.00 ; Volume is greater than or equal to 100 ; Open interest is greater than or equal to 1 ; Avoid selling deep ITM American style options and Avoid selling short stock. 12

Step 7 - evaluate the search output from Trade Finder: Individually, all the numbers i.e. W.C.R, E.R, B.C.R and P.P. are grossly overestimated because (for illustrative purposes) we are computing the calculations based solely on the closing bid/ask spreads. This is why we always study and compare just the ratios e.g. E.R/W.C.R & B.C.R/W.C.R together. Specifically, the ratio of the Expected Return to the Worst Case Return for all the suggested trades is 1. Likewise, the ratio of the Best Case Return to the Worst Case Return for all the suggested trades is 1. Moreover, OptionVue calculates the Probability of Profit to be 100% for all the suggested trades. Since all suggested trades all have the same ER/WCR and PP we select the trade with the greatest Net Price (Net Pr) for further study. In this case, that is the first suggested butterfly with Net Pr = 34.8. 13

Step 8 analyze the recommended trade(s) from Trade Finder: We analyze the suggested trade(s) from Trade Finder by calculating its risk/reward graph explicitly. In particular, based on our previously conducted volatility analysis we examine the butterfly with the highest theoretical Net Price (Net Pr) suggested by Trade Finder in the previous step. Specifically, we step through both 5 separate dates and 5 separate volatilities to determine how best to modify the suggested (-1370c, +1405c, -1440c) trade. In this case, we need to modify the suggested trade size to meet any anticipated margin constraints of our account. Specifically, the suggested trade size of (-96, +192, -96) needs to be lowered by a factor of 96. Again, this is something we determined by stepping through the 5 separate dates & 5 separate volatilities of the original suggested trade. 14

Step 9 modify the trade sizes and analyze the trade again Next, we modify the trade sizes explicitly to meet our anticipated margin expectations and analyze the whole trade again. Specifically, we reduced the suggested trade size by a factor of 96 i.e. changed the suggested trade size from (-96, +192, -96) to (-1, +2, -1). We like this butterfly options trade and determine to execute it explicitly via Interactive Brokers. To recap the whole Trade Finder process--we do not blindly follow the output of any one particular Trade Finder search output. Specifically, we take the first search results as just the general recommendations that we should consider for further refinement via modification (typically the suggested trade size needs to be lowered) and subsequent reanylization (plotting the risk/reward graph explicitly again). Moreover, we will have to repeat the whole process many times (over various different underlyings e.g. SPX, OEX, XEO, NDX etc.) just to build up even the initial portfolio. Finally, we have to rerun the search processes (at least once per day) to make any anticipated adjustments to our options portfolio. 15

Step 10 - put trade(s) on & monitor the portfolio using IB Risk Navigator: Once we build up our portfolio using the modified suggested trades from OptionVue Trade Finder we monitor our Interactive Brokers (IB) portfolio continuously during market hours using the IB Risk Navigator in Traders Workstation (TWS). Notice, in the lower right-hand corner that is says Live update. In other words this is the real money screen we watch. Specifically, we plot and track both the Equity Portfolio Value and Equity Portfolio Value Change in the Live update mode. In other words, we try to maintain this risk profile in real time. When we see that the shape is changing in a way that is not in our favor then we put on another trade (or modify an existing position) so as to get the risk profile back into its original shape. This is why we run the Trade Finder daily in continuous search mode. Specifically, we identify both potential trades and trade modifications of existing positions. This is to offset any possible changes to the risk profile's shape that we anticipate that the market's action may induce that day. To conclude, the risk profile is reproduced again below (in larger size) to provide more detail. 16