Owning $100 of the Nasdaq 100 ETF from April 1999 to May 2009 would result in this roller coaster ride (Click on the image to enlarge):

Passive Collar

We want to compare this to the collar strategy in each of the sub-periods outlined in the graph. The title on this graph in incorrect, we are comparing one month, three month, and six month puts. (Click on the graph to enlarge.)

Here is how the passive collar strategy does:

• The dark green line is the return for the strategy of owning QQQQ and selling at the money one month calls and buying at the money one month puts. It has a steady bond-like return where $100 grows to about $140 in ten years. That is a 3.4% compounded return.
• The purple line is the return for the strategy of owning QQQQ and selling at the money one month calls and buying at the money three month puts. Here, most of the increase is in the early period, from March 1999 to March 2003. Starting with $100, it grows to about $180 in this period and then in the next six years, increases to about $190. This is a 6.6% compounded return over the ten years.
• Similarly, the turquoise line, which is the return for the strategy of owning QQQQ and selling at the money one month calls and buying at the money six month puts, rises to $275 by September 2003 and then treads water until March 2009. This is a very respectable 10.6% compounded return over the ten years.

The passive strategy is most sensitive to the put expiration. So we look at 2% out of the money puts written six months out and see how the return varies with how far out of the money the one month calls are written.

This is for the whole ten year period:

• The passive collar strategy cut the standard deviation of return by two thirds from 30% to 10%. This is a very substantial improvement.
• Of course, it also turned a losing strategy, owning the Nasdaq, to a nine to ten percent per year winner.
• The maximum drawdown for owning the QQQ was 80%, nearly impossible to recover from. The collar had a maximum drawdown of 21% for the loosest collar.
• The correlation with the underlying increases as we loosen the collar by increasing the amount that the call is out of the money.

Active Collar

(Click on the graph to enlarge.)

The upper turquoise line is the short term active strategy. It turns $100 into $300 in ten years, which is an 11.6% compounded return. All the return was made by September 2003, the strategy treads water after that.

Tomorrow, we’ll look at what it all means.

Passive Strategies

On the Friday before expiration (on Saturday) sell calls on QQQQ that expire in a month and buy puts to collar the ETF. They tested using at the money options, 1%, 2%, 3%, 4%, and 5% out of the money options as well as 1 month, 3 month, and 6 month puts. So they tested 3 * 6 = 18 strategies here.

Active Strategies

The calls sold are all one month out and the puts bought are all six months out. But the number of calls is adjusted and the amount out of the money is adjusted as well. To do this, they look at three market signals, momentum, volatility and macroeconomic data, at three time horizons, short term, medium term, and long term.

Momentum Signal

To see if the market is trending up or down, they look at a simple moving average cross over. If the fast line is above the slow line, they take that as an up trend and if it is below, a down trend.

• Their short term signal is a 1 day simple moving average compared to a 50 day moving average.
• Their medium term signal is a 5 day simple moving average compared to a 150 day moving average.
• Their long term signal is a 1 day simple moving average compared to a 200 day moving average.

If the momentum signal is bullish, they widen the collar and move the call and the put one percent more out of the money. If bearish, they move them 1% closer to at the money.

Volatility Signal

Puts are always bought to match the number of shares of the ETF bought. Not so with the calls. If the market is in a state of “high anxiety” that is a bullish signal and so they want more exposure to the market. To do that, they sell only 0.75 calls per 100 shares. If the market is in a “low anxiety” state, that complacency is bearish, so they sell 1.25 calls per 100 shares.

They measure the anxiety level across the three time horizons.

• If the spot VIX is one standard deviation, or more, above the 50 day moving average of VIX we are in short term high anxiety state.
• If the spot VIX is one standard deviation or more below the 50 day moving average of VIX we are in short term low anxiety state.
• If the spot VIX is one standard deviation, or more, above the 150 day moving average of VIX we are in medium term high anxiety state.
• If the spot VIX is one standard deviation or more below the 150 day moving average of VIX we are in medium term low anxiety state.
• If the spot VIX is one standard deviation, or more, above the 250 day moving average of VIX we are in long term high anxiety state.
• If the spot VIX is one standard deviation or more below the 250 day moving average of VIX we are in long term low anxiety state.
• There is also a neutral zone, within one standard deviation of the moving average, where they sell 1 call per 100 shares.

Macroeconomic Signal

This is a two part process. If the NBER defines the time period as expansionary, new unemployment claims above the moving average is bullish is their claim. If we are in a recession, the opposite is true, new unemployment claims above the moving average is bearish.

• The short term signal is to compare the week’s unemployment claims to the 10 week moving average of unemployment claims.
• The medium term signal is to compare the week’s unemployment claims to the 30 week moving average of unemployment claims.
• The long term signal is to compare the week’s unemployment claims to the 40 week moving average of unemployment claims.

So if bullish, we want more upside exposure so shift the call and put to higher strikes. This shifts the collar upward. If we have a bearish signal, shift the call and put to lower strikes.

Trading Rules

Call % OTM = 2 + Momentum Signal + Macroeconomic Signal

Put % OTM = 3 + Momentum Signal – Macroeconomic Signal

Where the signals are +1 or -1 depending on the values described above. Also, puts are more expensive than calls so to get close to a zero cost collar, they start the put at 3% out of the money and the call 2% out of the money.

Number of Calls per Put = 1 + 0.25 * Volatility Signal

Tomorrow, I’ll discuss the results.

Here is a copy of the paper:

qqq_collar_study

We compare the BXM Buy-Write Index with the SPTR, the total return S&P 500 index which includes dividends. The S&P index has near zero return for this time period.

The BXM return is slightly higher than SPTR, but the standard deviation of return is much lower. So the return is much less volatile, so higher quality.

Since June 1986 $1 invested in BXM would grow to over $6 while SPTR would be $5.4 and three month T bills would grow to $2.73

The Russell 2000, RUT, closed yesterday at 604.28. So we could sell the Nov 650 call and buy the Nov 660 call; and sell the Nov 550 put and buy the Nov 540 put.

Call Spread

Conservatively, we would sell at the bid and buy at the offer. We might do better, but in that case, we would have (7.7 – 5.9) * $100 = $180 deposited in our account for each spread. What is our expected return?

If the probability to close above 650 is 18.4%, then the probability to close below 650 is 100 – 18.4 = 81.6%.

The Monte Carlo calculation says that RUT will close above our higher strike, 660, 14.4% of the time.

So our expected return, not even worrying about closing between 650 and 660 is $180 * 81.6% – $1,000 * 14.4% – loss inside (650, 660) – transaction costs = $146.88 – $144 – other costs. So this is not a good strategy. It has a negative expected return.

Put Spread

Doing the same thing for the 550 / 540 put spread. The premium is 10 – 8.9 = 1.1 or $110 per spread.

The probability for the put spread to expire worthless is 100 – 13 = 87% and the probability for maximum loss is 8.9%. So the expected return is less than $110 * 87% – $1,000 * 8.9% = $87 – $89 = -$2.

Iron Condor

Now to combine the two spreads. The probability for RUT to end up between the inner strikes so that all the options expire worthless is 100% – 18.4 %- 13% = 68.6%. Reading off the probabilities from the table above.

So the expected value of the condor is less than ($180 + $110) * 68.6% – $1,000 * 14.4% – $1,000 * 8.9% =  $198.94 – $144 – $89 =  -$34
Next we’ll look at adjusting and see how that might help.

I ran a few Monte Carlos to see if it mattered if you sold the near month versus the far and to get a feel for how often you would have to adjust given where you choose to play. These are for the Russell 2000 index, RUT.

So here, this close in, it doesn’t matter if we trade the near month, October or November. We’d have to adjust all the time, though it would close past one of the strikes between 60% and 65% of the time.

What happens if we move farther out?

This is much more manageable. One has to adjust about 25 – 30% of the time, though the market closes past one of the strikes less than 20% of the time.

Next question is, what happens if you don’t adjust? Take your lumps when the market closes past your short strike but sit with it and make the return when the market turns back around. Is that a good strategy or poor one?

Stay tuned.

Case-Shiller Housing Index Through April 2009

There is great variability between the cities.  Here are the results for each city in the index:

It would be great to hedge the value of your house so that further declines would be made up by an increase in a security. Well, MacroShares launched two Exchange Traded Trusts on 30th of June that track the ten city composite.

Or do they?

MacroShares Major Metro Housing Up (UMM) and Major Metro Housing Down (DMM) return three times the index and minus three times the index. But not month to month. They are designed to return the given multiple of the index in November 2014. Until then, they will fluctuate depending on investor sentiment.

Another interesting feature is that they transfer money between themselves based on the relative price. As more money comes into the funds, they buy Treasuries that they transfer depending which Trust is higher.

If they had launched in 2006, DMM would already be shut down, because the 10 city composite peaked at 225 and now it is at 150.  A 1/3 drop wipes out the Trust.

Because the trusts move to plus and minus three times the Case-Shiller index in five years, they can be used as a five year hedge for your house value.  If you sell your house before then, there is no guarnatee that the Trusts will reflect the change in housing prices.  They act like a warrant, trading on what investors expect housing prices to be on 31st August 2014, payable in November 2014.

In this final installment (for now), I’ll share more of my ideas about trading, and options trading in particular.  The purpose is to provide guidance for readers.  I’m not suggesting that you agree with, and adopt, all (or any) of these ideas.  Instead the purpose is to get you thinking about your own philosophy of trading and why my ideas may or may not be appropriate for you.

The bottom line is there’s more to option trading than merely slapping on a position and then waiting for the options to expire.

1) Make the best decision you can at the time the decision must be made.  Do not berate yourself if it turns out not to be the winning decision.

2) Stay within your comfort zone.  Never ‘hate’ any position you own. It’s easy to exit and find a better trade.

3) “It’s not good enough to find winning trading techniques; one has to continually adapt these techniques to an ever-changing environment.” So says, Dr. Brett – and I agree.

4) Don’t depend on ‘hope’ to salvage a bad position.  Use your intelligence to make a good trading/risk management decision.

5) I find that it’s too risky to try to earn every every last nickel from a trade.  Exiting a position early locks in profits and gives you a quiet period with no risk.

6) Don’t sell naked options.  The exception is for investors who want to buy stocks as prices decline.  For those investors only, writing naked puts is a satisfactory strategy.

7) Don’t use options to gamble.

There’s always more to say on any topic.  If you are so inclined, please share any of your basic trading tenets.

Some traders use options to speculate on the price movement of an underlying asset; other traders use options to speculate on changes in the volatility, implied or realized, of that asset.  Put a little differently: while no options trader can afford to ignore the role that volatility plays in the price of a contract, not all options traders are interested exclusively or even primarily in volatility. If you’re essentially a stock picker who likes to lever up by buying puts and calls, know that many options traders are doing something different from that.

Recall that there are three components that affect the value of an option: price, time, and implied volatility.* Changes in the price of the underlying asset will affect the price of an option on that asset, as will the passage of time and changes in expectations of future volatility. We measure the exposure an option contract has to those three components and report them as the greek variables delta, theta, and vega. (Vega is not a Greek letter, but it is a greek letter.)

Now, if you’re an options trader of the second type – i.e., not just a stock-picker on steroids – and you have a view to express about volatility, then you’ll want to reduce your exposure to other irrelevant variables. It’s like running a business: if you know you’re good at selling insurance, and if you’ve become one of the biggest and the best insurance companies around, then if you’re smart you’ll think twice before risking your entire company on your ability to make sausages (or to sell OTC credit derivatives, which isn’t so different: you put a lot of nasty stuff in a sack and hope not to hear from your buyers anytime soon).

That’s why options traders and authors in academic finance journals spend so much time thinking about delta hedging. It’s not really an optional line of inquiry, if you’ll pardon the pun: hedging away unwanted risks is a key survival tactic.  Traders who have a consistently profitable thesis about (or skill at trading) volatility will only be profitable overall if they can reduce or eliminate the impact of variables other than volatility. Delta hedging of some form or another is a necessary but not sufficient condition for successful options trading.

In the followup to this post, we’ll look at some popular methods for hedging away delta risk.

* Of course, interest rates and other carrying costs matter, too, but not nearly as much, and not enough to warrant discussion in this post.

A butterfly is a spread with three legs.  All three are calls, or all three are puts, and each expires at the same time.  A call butterfly combines the purchase of a bull spread with the sale of a bear spread of equal width [If the bull spread is 5-points wide, then so is the bear spread], with the proviso that the option sold in each spread is identical.

The ratio for a butterfly is: long one; short two; long one.

Here’s a butterfly spread that I held last week:

Long  12 RUT Jun 540 calls
Short 24 RUT Jun 550 calls
Long  12 RUT Jun 560 calls

Note this position is

Long  12 RUT Jun 540/550 call spreads
Short 12 RUT Jun 550/560 call spreads

There are other types of butterfly spreads, including iron butterflies and broken-wing butterflies.  Perhaps that’s a good topic for another post.

Unintentional?  How can I own an unintentional position?

I trade iron condors most of the time.  Last week I was still holding onto some June positions, against my better judgment. [But this time I got lucky and earned a good profit.  More often than not, I find holding these risky positions results in further losses.]

I had two June call spreads remaining, having recently covered the put spread portion of the iron condors at low prices.  I was short the Jun 530/540 call spread and the Jun 550/560 call spread.  Here is a list of my positions (but not using the correct quantities):

Embedded in those two call spreads are two butterflys.

I was long 12 RUT Jun 540/550/560 call butterflys (12×24x12)

I was also short 12 RUT Jun 530/540/550 butterflys.

I refer to these positions as unintentional butterflies because I did not originate the positions as flies, but as individual call spreads.  Nevertheless, those butterflies were in my portfolio.

If RUT were to rally to 550, the butterfly spread would be a winner.  But that’s not the way to evaluate risk because the 530/540 spread would lose the maximum possible amount, and my six extra calls would only help (up to 550) on a continued rally.

Above 550, I’d be facing immediate danger from the 550/560 spread.  Six extra longs don’t go very far when protecting a short position of 25 spreads.

NOTE:  Looking at values when expiration arrives, at 550, the six extra calls would be worth $1,000 apiece.  Because I was short 25 Jun 550 calls (and still long six 540s), for each point above 550, I’d lose $1,900 – up to a maximum of $19,000.  After 560 the losses stop and my six extra calls would produce $600 per point.  But this is a very risky position when RUT is trading that high.  the position was bad enough at 530, but I did not want to face that trouble if we rallied far above 550.

Thus, I sold my call butterfly spreads.  My rationale was that it reduced risk if we rapidly rose above 550 (yes, I understand if that happened I could sell the fly at a better price as the index approached 550), and would provide extra profits if RUT ended its rally and headed lower.  The point of this story is that I had a butterfly embedded in my position and made a trade it when I thought the price was good enough ($1.30).

The position looked strange after the trade, but was still easy to manage.  As it turned out this time, the market receded and the June positions were readily closed.

Position after butterfly sale:

When you own flies, the best result occurs when expiration arrives and the underlying asset is very near the middle strike.  Then the bull spread (you bought) is worth near its maximum value and the put spread (you sold) is worthless (or worth very little).

Thus, holding has benefits.  The spread can continue to increase in value.

But, holding is risky because if the market moves and the three options are out of the money (or in the money) at expiration, then the fly is worthless.  Thus, it’s best to sell a fly at some point.  But choosing that point is a difficult proposition.  I’m sure some fly traders have their individual guidelines, but I was pleased to collect that $1.30 with a week and a half remaining before the options expired – and especially when all the options were OTM at the time I sold the fly.

If you have
more than one iron condor position for any given expiration month,
take a look the possibility (don’t jump in without a good understanding of how to handle the residual position) of trading those embedded flys for additional
profit opportunities.

Erin asked:

Let’s also assume that the short option is 10 points farther OTM than the long option.

The last assumption is that we will exit a position as the adjustment of choice.

***

Iron Condor

With an IC, you are short a call spread that can become worth $1,000 (worst case); and you sold it for far less.  Our responsibility as risk manager, is to prevent that (or any similar loss) from happening.

The danger occurs as GOOG approaches 440.  If holding or closing the trade is the only consideration, I recommend establishing a maximum acceptable loss, and if and when that point is reached, exit.  That may when the call spread reaches $4, or $5, or whichever price your comfort zone allows. [Remember that if you bought the IC and collected $3 originally, then paying $5 is not the disaster it would be if you collected only $1.]  Your decision is when to pull the trigger.

Ratio Spread

With a ratio spread, you face a far different situation.  This time you own the 440s and are short twice as many 450s.

There’s the good news:  You own a spread that is ITM and is heading towards the point where it will reach maximum value of $1,000 (if it remains there at expiration).  So that’s a better situation than you faced with the iron condor.

But, you are short two calls instead of only one, and the second is a naked short. Some brokers do not allow customers to carry naked short call positions.  But, if you are allowed to do so, it’s considered to be a risky trade and I no longer allow myself to own such positions, but that’s not the point of this discussion.

Once GOOG moves past 450, then the naked short option quickly eliminates any profit you had from the 440/450 call spread [Mentally breaking this trade into two parts: the call spread and the naked short].  In fact, if there is much time remaining before the options expire, the position quickly turns into a  loser, with the loss mounting as the stock rises.

When there’s very little time remaining, the position still has terrible negative gamma, but the limited time prevents the extra 450 call from exploding.  If time runs out (the market closes on expiration Friday), and if GOOG is under 460 (your break-even point if you paid zero cash to establish the position), things are not too bad.  Obviously, a lower price is better.

The major factor in deciding whether to hold or exit is going to be time.  With expiration rapidly approaching, you may still want to exit because you probably have a profit (although it’s only risk that should matter, but I know that most traders only want to know if they have a profit or loss, and risk be damned.  This is not good thinking, but it is the way the world turns).

Thus, it’s possible to have a good profit as the stock moves towards 450, and that profit possibility makes this trade look ‘better’ than the iron condor – which has virtually no chance of being profitable as GOOG moves towards 440 – a full 10 points lower!

The ratio has a higher profit range, but there is that ‘unlimited loss’ possibility that makes it more dangerous to own.  In response to your question Erin, I’d rather have the adjustment decision with this position than with the iron condor.

This is just another personal comfort zone decision.  The optimist  understands that the stock is currently at its sweet spot, but danger looms.  The pessimist sees the danger, and may fold in the name of safety.

These are interesting positions to own, but I have removed them from my arsenal of strategies – just because I do not want to face a margin call (whcih can happen as the stock rises) or a nightmarish stock market opening gap.

Broken-Wing Butterfly

With a BWB, you are short a 20-point spread, and the maximum loss is $1,000 less the premium collected to open the trade.

This is essentially the same as the ratio spread, but this time you are not naked short any options.  You own the 470 call and there is neither a potential margin call nor an unlimited loss in your future.

I’d treat this spread the same as the ratio spread because it is the ratio spread.

Erin,

I hope that helps.  The iron condor is really the odd man out.  The other spreads are similar to each other and the IC trades very differently.  IMHO, the ratio (better yet the BWB) is easier to adjust because time is THE consideration.  Iron condors are risky at all times (if the short strike is approached).