Archive for the ‘Options’ Category

Closed SPX and RUT Iron Condors for August

August 19, 2009

Yes, I’ve filed for a divorce with high-probability trading, but there is the matter of leftover trades that must be dealt with. These are the last Iron Condors I’ll be doing for a while. The next one I do will be hatched under the roof of systems trading. You’ll see that I didn’t do what I said I was going to do with both these trades, and my assumptions about what the market was going to do for the next six weeks was completely wrong. I changed my mind as the market conditions changed, and in the mean time I endured the rather unpleasant emotions of dread, loathing, fear, resignation, hope, more dread and so on.

I put on the SPX Iron Condor trade for August at the strikes of 785/790 (puts) and 1010/1020 (calls). My credit was $1.15. You will notice that I skewed the trade towards the downside. My risk was greater on the upside ($10 on the call spread) than on the put side ($5 on the put side). The reason: I wasn’t too concerned about a rally, but more concerned about retesting the lows. Okay, you can laugh now.

I put on the RUT Iron Condor trade for August at the strikes of 450/460 (puts) and 560/570 (calls). Credit received was $3.15. My reasoning was that the market wasn’t going anywhere for a couple weeks, and I would take the trade off for a small profit with more than two weeks to expiration. Yes, you can continue to laugh.

If you trade with discretion, you really need to get past the fact that you will be wrong at times, sometimes dismally wrong. Discretionary traders who have been stung by wild market action that is in complete contradiction to their views tend to hedge their opinions going forward. I’m not going to make attempts to convince anyone that they should hedge their opinions in the market. Not because I’m concerned about you neophytes not listening to me, but only because it is completely worthless. Worthless because it takes personal experience to learn this lesson in trading, and good-intentioned words from others probably does more to hinder your development as a trader than help. Pay your own tuition. It’s the only way.

An Iron Condor is a hedged position by definition, because your further out strikes protect you from unlimited loss. The SPX trade this month had a total risk of $8.85 for a potential reward of $1.15. The RUT trade had a risk of $6.85 for a potential reward of $3.15. Not your typical positive expectancy scenario, but this is the strange world of options we’re talking about here.

Anyone following the market in the last few weeks would have observed that the SPX breached the short strike of 1010 and almost hit the hedge of 1020 intraday. In the RUT, the short strike of 560 was breached and the hedge of 570 was also breached as the index traded at 577 intraday. That’s enough to discourage just about anyone. It’s usually around the time when the price starts touching your short option that you begin devising ‘adjustment’ plans. You can move your short call spread up a strike by simply purchasing a like-option butterfly. For example, to move the RUT 560/570 call spread up to the 570/580 strikes (which gives you more breathing room), just buy the 560/570/580 call butterfly. Diagram it out on paper, it works.

Adjustments cost money though, and it doesn’t take long for you to become confused as to what you’re trying to accomplish. I chose not to make adjustments.

On Wednesday before expiration (tomorrow is the last day to trade AUG SPX and RUT options), I took the trades down. That is, I took off all the risk.

For RUT, I decided that buying the 500/560 AUG strangle was the best choice. It was marked around $4.20 before the open, but the futures were down so I put in a standing bid of $1.99. While I was buttering my toast, I heard the opening bell ring. Sauntering over to the monitor, I noticed that the order was not working, but was in fact filled. Holy smokes, that was fast! Okay, good. No risk is left and I have a small profit.

Next up the SPX Iron Condor. The strangle approach wasn’t working out so well. I had a bid for the 800/1010 strangle for $0.75 and when I saw it being marked at $0.62 after the open, I canceled and replaced it with a bid of $0.50. The spread got away from me and went to a $1.00. Now the sell-off from the close was getting challenged and that 1010 call was getting more expensive to buy back. The 800 put was going into no-bid land (zero bid, ask a nickel) where nobody wants to fill you. It was mucking it up. Another approach was to buy back my short 790 put for a nickel and work on the short 1010 call. And that’s what I did. Bought back the 790 put for $0.05.

I realize it’s hard to keep track of all this, but you will recall that though I neutralized my RUT Iron Condor (took off all risk), I still had long options, namely the 460 put (worth less than a nickel) and the 570 call (worth around $0.80). I was thinking of the long 570 call as a hedge against a melt-up on the markets and against my short 1010 call in SPX. Different markets, yes, but it helped me take a breath and consider an orderly exit strategy.

I bought back the SPX 1010 call for $0.90. That made the profit total $0.20. Big whipty do, I understand. But remember I was facing a loss of over $8.00 just last week. Now with my risk in SPX off, I sold the RUT 570 call for $0.65, and the long 1020 SPX call for $0.30.

After all was said and done, the profit from the SPX Iron Condor totaled $0.50, and the profit from the RUT Iron Condor totaled $1.81.

I was worried that when I announced my break-up with high-probability discretionary trading, she would sell my golf clubs to the punk kid next door for $20. But she hasn’t done that. Maybe she wants to get back together, who knows. You never can tell about these things.


FAS and FAZ dual covered call trade closed

July 17, 2009

After playing around with this multi-dimensional derivative on derivative trade, I have closed it for a net loss of $0.06. My habit of buying back short options for a nickel is what kept this trade from being a winner. As in a total of $0.19.

What’s curious is that the credit taken in for short calls almost made up for the inherent price decay of the triple-leveraged financial ETFs. On a theoretical basis, the decay of OTM calls and the price of the ETF are almost identical.

I received $5.23 of credit during the 3-month experiment. We need to take away from that total the purchase of short calls for a nickel when they became available and my purchase of the FAS in-the-money call Friday afternoon. This totaled a debit of $0.75 against credit received for a grand total of $4.48 net credit.

I needed to buy back my ITM short FAS call expiration Friday afternoon to close the trade because it was ITM and I would have gotten my long stock called away anyway. I just avoided exercise fees and put this experiment in the books a few hours early. I paid $0.50 to buy back the ITM FAS call, the first time in three months I was faced with a short call being ITM.

The price I paid for long FAS and FAZ, and the price I received for their sale totaled a debit of $4.54. Even though these ETF are inverse each other, the purchase of both simultaneously is not a perfect hedge. In fact, it’s not even close. After three months and accounting for the reverse split, the decay was a stunning 25%. That’s not annualized.

About the only way to play these products is on a day trading basis, or maybe short them. Both of them. You’ll need to have some sort of Black Swan hedge in place, but I’ll let you figure that one out.

This brave new world of trading in which we can ‘invest’ in triple short ‘stocks’ in our IRA is quite interesting. Going long these ETFs makes about as much sense as being long OTM calls. But those regulating our retirement investments deem both these products suitable. Let’s not let the public short stocks in their retirement accounts though. That would be risky, you see.

RUT Iron Condor for August

July 2, 2009

Bulls and bears are on summer vacation. But they left their children behind to keep the market humming along during their well-deserved break. So as the cubs and calves fight it out, I expect much ado about nothing. Enough so to put on an Iron Condor in RUT, the European-style, cash-settled index that tracks the Russell 2000 small caps.

I’m not playing it safe on this one, but I don’t expect to carry it through to expiration. I’ve chosen the 20 delta at the short strikes, which is almost a coin flip in terms of probabilities. I’ve also taken this trade with a little too much time to expiration. Normally, I will take an Iron Condor with a max of 48 days to expiration, but this time I’m playing the summer holiday and hoping to steal some extra theta.

The strikes on the put side vertical are 450/460. On the call side vertical they’re at 560/570. Credit received is $3.15.

The general idea is to take this trade off when price action threatens the short strike. And hopefully I’ve eroded the short strikes enough to get a profit from the trade.

SPX skewed Iron Condor for August

June 30, 2009

It took a while to convince me that the market is spinning its wheels and not ready to blast off or blow up in the next few weeks, but now that I’m convinced I put on the only trade that anyone would put on in a sideways market: the Iron Condor.

My underlying vehicle of choice is SPX, which is the cash-settled, European-style index that tracks the S&P 500. It’s big, it’s liquid and it’s cool. On the downside, they still use open outcry for this market, which means that suffering from slippage is just part of the game.

When constructing this spread, I had in mind that I’m gonna let it go for the full cycle. That means I’m going to exit the trade in 51 days and let the chips fall where they may, I’ll be able to handle it. Fifty-one days out for an Iron Condor is a little on the long-term side. I’m stretching my upper limit of 48 days that I typically apply to putting these spreads on, but I also have a good reason for doing so. July 4th weekend. Everyone is gearing up for the summer season with this long weekend, which I take to mean that nobody will be feverishly following the markets, at least nobody with serious capital to move it.

First step is setting up the spread: decide on the delta of the short strikes. Remember from the beginner’s guide to options you once read that at-the-money options have a delta of .50. So you’re gonna have to pick something under .50 but greater than zero. We could go into how the delta reflects the probability of expiring, but quite frankly I don’t buy any of those arguments and so I won’t bore you with Gaussian probabilities. Let’s just say that the lower the delta of the short strike, the less chance it has of being in-the-money at expiration.

It follows that if you have less chance of becoming in-the-money than your neighbor, you should get paid less, because you are taking on less risk, ostensibly. So keep this in mind. I chose to explore the world of 10 deltas on the put side and on the call side. That gives me a roughly 90% chance of staying out-of-the-money at expiration. Ooops, forget I said that. It gives me a pretty darn good shot at having my short option expire worthless. There, I feel better now.

With the 10 delta as our guide, we can easily identify the put side at the 790 strike and the call side at the 1010 strike. That’s where we start. Now we buy protection against the Black Swan events which rarely happens except last year when it rarely didn’t happen. We are going to buy calls and puts that are further out-of-the-money so we end up paying less for protection than what we receive for assuming risk. Normally, you pick equidistant strikes for protection on the put side and the call side, but this month I’m employing a little skew action. I’m worried about everyone waking up tomorrow and finding out that our market is worth a lot less than we’ve been led to believe. That leads to a selloff, which hurts the put side. So to give myself a little short delta bias, I’m putting the put side insurance only 5 points away, and the call side insurance 10 points away. The result, a 785/790 put vertical and a 1010/1020 call vertical.

This was marked at $1.30 credit when I constructed it. The SPX options have very large bid/ask spreads (I guess because the open outcry method needs to give shouting market makers a chance to take a drink of water). With this in mind, slippage is the cost of doing business. I put in an order for $1.25. Nothing. Okay fine, you can have another dime. Limit order of $1.15. Filled right away. Oh great, that didn’t feel right. Oh well, I’ve got my trade on for the summer doldrums.

The management of this trade is the easy part. Close your eyes until expiration and then look at your account balance. Hopefully, you get to keep the paltry $1.15 credit. Worse case you end up giving that money back and ponying up $8.85 of your hard-earned trading capital.

XEO JUL/AUG 360 Put Calendar closed

June 29, 2009

The stock market rally of the century has decimated my short play, the XEO JUL/AUG 360 put calendar. When the front month hedge against the back month long option erodes to less than 10% the value of the long option, it’s time to throw in the towel.

The trade was put on about six weeks ago for a debit of $3.45. Credit received for closing the trade was $1.45, which nets a loss of $2.00. This spread actually got to break-even on Jun 22, just a week ago. But the biggest sell-off in weeks was erased in the subsequent days.

There are still 18 days left on the short front month put, but since its value has eroded substantially, it offers no hedge against theta risk for the long AUG 360 put. With the holiday weekend coming, negative theta would only hurt this trade, and the only salvation would be a series of sell-offs, dropping the value of the S&P 100 and raising volatility.

Personally, I don’t see that happening as everyone is on vacation, creating low volume and a general sense of lethargy and malaise.

What I am looking at closely is the relatively low volatility in the market. Long put calendars work in this environment if volatility increases and/or price action goes lower. It didn’t work on this trade, but then again you don’t get the rally of the century every month.

Eroding options on eroding assets: FAS, FAZ and their calls

June 17, 2009

Whew, that was quite a ride on the FAS/FAZ train this month. My premium collecting strategy has dodged the bullets of having my lovlies called away from me. I sold calls at the 10 strike on both FAS and FAZ last month, and today was able to buy back my lonely FAS JUN 10 call for a nickel. I bought back the FAZ JUN 10 call for a nickel, I don’t remember, maybe two weeks ago.

But this fun and games also has a downside. I am the owner of perpetually eroding assets, namely long the triple-leveraged ETFs. I calculated what my effective stock decay has been since I bought them a mere two months ago, and compared it to the option decay that I benefited from. View the horror on the chart.

These ETFs are eroding faster than 30 day-out freekin call options! And they’re OTM options to boot.

This next option cycle is show time as I’m no longer selling the 10 calls in both underlyings. In fact, I’d like to get off this roller coaster and have dutifully sold ATM calls in both. That means I sold the JUL 9 call in FAS and the JUL 6 call in FAZ. One of them will have to get called away next month.

Credit received is another $1.82. When one of these gets called away next month, I will be the owner of either FAS at the effective price of $7.06 a share or FAZ at the effective price of $4.06. The math is roughly correct.

Let the games continue.

It’s a race – FAS, FAZ covered calls

May 15, 2009

With the price-decay nature of FAS and FAZ, being long both is a double whammy. The expectation that one will blast off and make a winner out of the pair is becoming pure fantasy. But the volatility in the options enables one to write covered calls, which deteriorate at a faster rate than the underlying is decaying. At least for now.

The trade is to sell a decaying asset (out-of-the-money calls) against a decaying asset (long stock in triple-leveraged ETFs). Because these ETFs are leveraged like they are, implied volatility in the 200% range is about normal. That equates to a lot of premium for covered call writers. Now the question is which asset is decaying faster – the stock or the OTM calls.

I’m betting the OTM calls. And that’s why I’m still owner of these pathetic investment vehicles. I look at it as stock rental, rather than ownership. I could just write naked calls, but what if I’m wrong about neither of these ever being able to blast off? Naked calls are scarier than naked puts because your risk is truly unlimited, whereas the naked put is limited to zero.

I got $1.71 credit for the MAY cycle, and paid a nickel apiece to take off the risk. So my MAY credits netted $1.61 per 200 shares (100 shares FAS, 100 shares FAZ). I sold the JUN 10 calls for $1.70 total and expect a rerun of MAY. If I’m right, my cost basis for the long FAS, long FAZ pair will continue to go lower. Hopefully my cost basis goes lower at a faster rate than the inherent price decay.

XEO JUL/AUG 360 put calendar

May 15, 2009

Yes, putting on a long put calendar is a directional trade that profits if the stock goes down, but it’s more than that. On Thursday, I put on the XEO JUL/AUG 360 put calendar for a debit of $3.45.

We’ve had quite a rally over the past several weeks. And just when you think the bulls have exhausted their ammunition, along comes another fusillade of buying. When will this rally end already? The long put calendar is a way to play the market short AND play the current volatility long. You basically have a couple of factors that contribute to your success. First is price action. Obviously, as price action declines a short delta position will be in position to benefit.

Next is volatility. When markets sell off, the volatility normally increases as every worried mouse runs out to buy protective puts, bidding it higher. When you have a long put calendar, you are long vega, which means that you win when the thing you’re long (ie, volatility) goes up in value.

And let’s not forget positive theta. You’re long put calendar will accumulate theoretical monies each day that goes by, because your short put in the front month will decay at a faster rate than your long put in the back month.

So, this is a directional play in both the price and volatility arenas. I think the rally is a little overbought and due for a correction. And I also believe that the current volatility is oversold and also due for a correction. The VIX-style volatility index that tracks the OEX is the VXO, and it settled at a low-of-the-year yesterday in the $32 range.

The XEO is a European-style, cash-settled index. It’s twin is OEX, which is the American-style version. Both track the S&P 100. I’ve chosen the XEO because of some chicanery that happens with early exercise in the OEX product.

DIA 70 put calendar closed

April 27, 2009

Originally taken as the MAR/JUN 70 put calendar, I got one roll out of it before I decided to close the trade for a small profit.

The initial debit of the calendar spread was $1.99, and that represents the total risk of the trade. The first roll bought back the short MAR 70 put and concurrently sold the APR 70 put. Credit received was $1.33. At that point, the trade looked promising as 2/3 of the risk was taken off with two potential rolls left in the trade.

But then the market rally of the century took place and ran my short APR 70 put to a nickel, at which point I bought it. That short front-month put is a hedge against time decay for my back-month long 70 put. Once that hedge disappears, you’re left with a naked long put, in this case a 70 put in JUN. Long puts with no hedge are not long-term viable. Not only do you need a move in the direction of your put, but you need a big move. Working against you is time decay, which erodes the options value as days go by.

Once of calendar trade falls apart and you’re left with an orphan long option, you either close the trade or assume the time-decay risk of an OTM option. I closed the trade and sold the long option for $1.32. Adding up the credits, $2.65 received. Adding up the debits, $2.04 paid. The net was $0.59 credit on an investment of $1.99.

Even when calendars do not ‘work out,’ you still can get a 30% return on investment. And that’s not annualized. The trade’s duration was about 12 weeks.

SPY 83/85 call spread goes to full loss

April 19, 2009

The APR 83/85 short call spread went to a full loss on expiration Friday. The loss amounted to $1.45 on the 2-point spread because of the initial credit of $0.55 that was received on March 20, 2009.

When this trade was taken, there was 28 days to expiration. At the time, SPY was trading just under $77. It closed on expiration Friday just over $87. That’s over 12% in about a month. I won’t bother annualizing that rate of return. Unfortunately for this trade, that is a rally it didn’t expect. Using the traditional methods of calculating probability of success, there was a 77% chance that SPY would not hit my short strike of 83 in the last 28 days. The chance that it would exceed $87 stood at 9%. Hmmmm. This is enough to make one ponder the validity of probability of success as a statistical measure. Or maybe we’re just experiencing some very volatile times. Let’s investigate.

The VIX, which measures volatility in the S&P 500, would be the place to look for what happened to volatility during our 28 days. Remember, SPY is an ETF for the S&P 500, so VIX is valid measure of its volatility. VIX closed around $46 on March 20 and closed at around $34 on expiration Friday. That’s a decrease of over 26%. Nope, we cannot attribute this unusually large move to an environment of increase volatility.

We can let it go and attribute it to bad luck. After all, we limited the risk on this trade and knew going into it what the loss could amount to. We took a trade that had a high probability of success with an additional edge of positive theta (time decay).

At the heart of calculating the probability of success is a Gaussian distribution of price around a moving target of standard deviation. In the option world, standard deviation is volatility. The theory behind option writing, or selling option spreads, is that the market is efficient at distributing information to all its participants and that price action follows a random walk. In efficient markets, it’s not possible for a trader to gain an edge and actually profit in the long term. So why even pursue selling options? The reason is theta. The edge premium sellers have is time decay. Maintain a positive theta position and you’ll gather profits over the long term.

It’s no great feat to persuasively argue against efficient market theory and against a random walk theory (prices have no memory). I’ll leave that for another time. Right now I’ve got a bone to pick with probabilities based on market volatility. Every option premium seller will acknowledge the Black Swan. Essentially, a statistically improbable event that should almost never happen, but happens all the time in markets. I read that there were 12 greater-than 4 sigma moves last year, including a fair share of 5 sigma and 6 sigma moves. A sigma is a standard deviation. The classic Gaussian bell curve puts the probability of a 3 sigma move at the very tips of the bell curve and ascribes its probability to less than 1%. The quick fix for that in trading is to describe markets as having fat tails. And the way the option world takes care of this pesky problem is to point to all the non-zero bid options way, way out-of-the-money. When trading the options in the middle of the bell curve, you get no credit for fat tails. So whether you use delta of the option or a fancier calculation to determine the probability of success, you need to understand going into the trade that your chances are dependent on the arrival of Black Swans.

A quick note on how this trade was closed.

Since I was short the 83 call, it was assigned to me. In other words, the holder of the option wasn’t stupid enough to not cash-in on a winning ticket. For a brief moment I was short SPY at the price of $83 a share. But that was a brief moment as my long 85 call essentially canceled out the short stock position by being exercised. My broker automatically exercises long in-the-money options so there was nothing I needed to do. Except gaze in horror at the week’s rally.