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

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.

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.

One way to think about a diagonal spread is to decompose it into a vertical spread and a calendar spread. The example he uses below is

+10 GOOG Oct 480 Calls
-10 GOOG Sep 470 Calls.

This is equivalent to:

Vertical Spread

+10 GOOG Sep 480 Calls
-10 GOOG Sep 470 Calls

And a

Calendar Spread

-10 GOOG Sep 480 Calls
+10 GOOG Oct 480 Calls

We just add and subtract the Sep 480 calls. I find it easier to use the two positions to think about the diagonal since they have different characteristics that combine into the diagonal.

Double diagonal (DD) spreads provide profit opportunities that are not available to iron condor (IC) traders. But, from the point of view that it’s possible to lose more money per spread with a DD than with an IC, they can be riskier investment choices. One immediate disadvantage is that they have higher margin requirements. While reasonable brokers have identical margin requirements for an iron condor as they do for either of the spreads that makes up that IC (no additional margin to sell a put spread when already short a call spread). That’s not true with diagonal spreads. A double diagonal has twice the requirement as a single diagonal. That makes no sense to me, but I have no influence over brokers and their rules.

The margin requirement for a diagonal is the difference between the strike prices, less the credit collected (if any), per diagonal.

Trading RUT iron condors, I choose strike prices that are 10-points apart. These simply feel comfortable to manage than when the strikes are near each other – but that’s a personal comfort zone decision, and not a recommendation.

When trading diagonal or DD spreads, I use strikes that are farther apart. I confess that this is not based on a sound, mathematical rationale. It’s based on the fact that I prefer to own a diagonal spread that provides a cash credit, or a small debit. Because of the pricing of RUT options, most of the time I own a diagonal spread in which the strike price of my month2 long is 30 points away from the strike price of my month1 short. Occasionally I buy the position when the strikes are only 20 points apart and find these 20-pointers to be easier to manage.

If RUT marches strongly through the short strike, the maximum loss can approach $3,000 per spread (less any time premium remaining in the long option).

I look at it this way (referring to just the call spread, although this point applies equally well for the put spread): If I have a position similar to:

Short 10 GOOG Sep 470 calls

Long 10 GOOG Oct 480 calls

the position is not going to do well on a quick upside move through 470. Thus, there’s upside risk. If I pay a big debit to open this position – say $500 – then there is also downside risk. If GOOG drops too far, especially if a few weeks have passed, both options may quickly move towards zero and most of that debit can be lost. Thus, I trade these spreads to avoid the chance of losing in both directions. [Yes, if it's a double diagonal, the downside move threatens the put spread, but at least it will not also hurt the call spread.]

DD Opportunities Absent from IC

To offset that extra risk, there are profit
opportunities not possible with iron condor positions.

1. If the stock moves toward one of the strike prices – and especially if some time has passed, instead of facing a loss as the iron condor trader would be facing, there’s a good chance that the diagonal spread could be closed profitably. Whether that comes to pass is going to depend on how much time remains before the front-month option expires, and the current implied volatility of the calls you own.

2. If closing doesn’t appeal, and you prefer to hold this position, selling the calendar spread when it is nicely priced (the stock trading near the strike price increases the value of a calendar spread) allows you to take cash out of the trade. In the GOOG example, you sell your GOOG Oct 480 calls and replace them with Sep 480 calls. That’s selling changes the position from a DD to a combination spread. It’s half an iron condo on the call side and remains a diagonal on the put side.

If the position soon becomes risky to hold, you can use some of that newly- collected cash to pay for an adjustment. Alternatively, you may elect to exit.

3. If enough time passes and if the underlying moves far enough away from one of the strike prices, you may be given the opportunity to repurchase one of the options you sold at a very low price. Looking at that GOOG spread again, if the GOOG SEP 470 calls are available, you may decide to cover them by paying $0.20.

When you do that you have two good choices. The first is to sell the Oct 480 calls, closing half the DD and probably earning a decent profit. The second choice is to sell the Oct 470 call spread, converting the call portion into half of an October iron condor.

Deciding which is better is going to depend on the price you can collect for the Oct 470 call and how attractive it looks to own that specific GOOG Oct call spread. Do not make this trade unless you want to own the position. There’s nothing wrong with exiting the trade.

The possibility described above was discussed in the comments to Part I.

4) If IV explodes higher and if your underlying has not moved so far that your position is endangered, you can collect on that IV surge by selling two calendar spreads and converting the DD (which you want to own when IV is low) into an iron condor (which you prefer when IV is high – because it’s too costly to buy the vega-rich DD spreads). Of course, if it’s attractive to do so, you may choose to exit the DD instead, and pocket the profit.

The new IC may run into trouble in the volatile market, but selling the two calendar spreads allowed you to own this position at a very favorable price.

Double diagonal spreads are more flexible than iron condors, but they are rich in vega and you want to own them only when you believe IV will be increasing – or at least not decreasing. If IV feels too low to be trading iron condors, you may decide to compromise and own some iron condors and some DD spreads. Or you can open the combo spreads: Half an iron condor on the call side and a DD on the put side [or vice versa, but a downward move which hurts the put side of the IC may not be hurt as badly when you own the extra vega that comes with the diagonal].

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).

He knows his way around options and his blog has some interesting posts and discussions. Here he discusses diagonal backspreads as a way to profit from a market move. He wrote these at the end of March when the market was moving up. It is something to keep in mind if the market ever breaks out of its range and moves down (or up some more).

In Back Spreads Standard and Diagonal he talks about the risks of a credit spread. Say you sell XYZ June 90 and buy XYZ June 100 calls. If XYZ is trading at 92, you can do that for a credit. The risk is that XYZ finishes somewhere between 93, say, and 100 where the calls you sold are more expensive and the calls you bought, the 100s have no value.

In a backspread you sell 10 XYZ June 90s and buy 15 XYZ June 100s. Here you might be able to collect a small premium, which if XYZ goes the wrong way, down, would be your profit. If XYZ moves past 100 those five extra calls give you unlimited upside. Again, if XYZ finishes below 100 your long calls are worthless and your short calls could put you in the hole for $1,000 each.

In the next installment of our saga Back Spreads Standard and Diagonal II he takes as an example the Russell 2000, RUT, which was at 429 at the time. The diagonal constructed is sell 10 May 460 Calls @ 16.70 with a delta = – 363
and buy 16 June 500 Calls @ 11.70 with a delta – 369. So this is delta neutral initially.

This might help you to follow his discussion.

One way to look at this is as a calendar spread of -10 May 460 Calls/ +10 June 460 calls; and a backspread in June -10 June 460 calls / + 16 June 500 calls. We have just added and subtracted the 10 June 460 calls. The calendar spread does well if implied volatility increases and the June backspread does well if the stock rises rapidly to overcome the drag of time decay and decline of implied volatility which usually accompanies rising stock price.

You can triangulate the position the other way too. That is, it is equivalent to a May backspread -10 May 460 Calls / + 16 May 500 Calls and a calendar spread -16 May 500 Calls / +16 June 500 Calls. The backspread wants a move clear through 500 or not to reach 460 and the calendar spread wants an increase in implied volatility.

The last in the series Back Spreads Standard and Diagonal III shows the return graphs with the effect of changes in implied volatility. It doesn’t show the effect of time decay which would give a surface. Worth reading.