Market Neutral Option Strategy?

This is a discussion on Market Neutral Option Strategy? within the Futures & Options forums, part of the Markets category; This is an idea that was spawned by a posting on elitetrader. Markets tend to move sideways 65% of the ...

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Old Apr 6, 2004, 10:39am   #1
 
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Market Neutral Option Strategy?

This is an idea that was spawned by a posting on elitetrader.

Markets tend to move sideways 65% of the time and trend only 35% of the time, give or take a few %. Traditionally that has meant calendar spreads, short strangles, short butterflies, iron condors etc. Trouble is, short strangles have unlimited risk in the event of a big move. Short butterflies and condors have limited risk, but even if you diversify by having a range of them on different stocks, a major geopolitical event may move all stocks/indices sufficiently to ensure that they all move out to the wings and all will suffer a loss, albeit limited.

So having just got in from a bracing walk, I thought I'd run this one past you. Select identical numbers of stocks in 2 groups - one group are those running into resistance which is expected to hold, and the 2nd group are those that have found support and which is expected to hold - say 5 in each group. For those that have come up against resistance, place a call backspread (i.e. with stock at (say) 98, sell 1 x 100 call and buy 1 x 105 call). Max risk is 5 - the gap between the strikes. Likewise for those at support, place a put backspread (i.e. with stock at 102, sell 1 x 100 put, buy 1 x 95 put).

My thought is that if the market moves sideways, as it does much of the time, most supports and resistances should hold and you'll keep the premia taken in on both the call and the put backspreads. 1 or 2 may break thru their support or resistance, but if say 7/10 stay the right side of their s/r then there will still be a profit.

If there is a major event and the market plummets, then the expectation would be that all the supports would fail and you'd loose on the put backspreads, but all the call backspreads would expire worthless so that you'd keep all the call premia taken in, so overall you'd still breakeven.

Likewise, if the market spikes up suddenly, the expectation would be that all the resistances would breakout, so you'd loose on the call backspreads, but the put backspreads would all make money and again you'd more or less breakeven. So overall the strategy should make money in a sideways market, which is about 65% of the time, and still breakeven on a sudden move in either direction.

I'd envisage this as a bit like a fishermans night-line - set it up and leave it alone until morning - or in this case, expiry - and come back and see what you've got. But if you felt so inclined, on (say) a convincing breakout thru resistance, you could buy back the short call at a loss and let the long call run.

Still haven't decided on best way to select stocks. Probably start with looking at sector charts, writing the call backspreads on stocks from a weak sector, and sell the put backspreads on stocks from a strong sector.

Anyway - those are the bones of the idea - a sort of market neutral strategy where big moves are neutral and sideways markets enable you to collect premium. The key, IMHO, would be to ensure that you have the same $ values for both the call and the put backspreads, and that you have a number of these simultaneously to spread the risk - probably at least 5 of each, and preferably more.

Any thoughts or comments?
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Last edited by RogerM; Apr 6, 2004 at 10:44am.
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Old May 21, 2004, 4:42pm   #2
 
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Interesting strategy. The key here is to know which shares are going down so to sell call spreads on them and which shares to choose for put spreads. If you are not sure about this choice, you might be better off with index options.
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Old May 24, 2004, 1:13am   #3
 
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RogerM started this thread Vladimir - I agree that index options are often favourite, but also trying to add some additional value with other strategies. My initial thoughts on this strategy is to look at sectors, and in particular look at market breadth data to see whether the potential bottom/top has any "legs" to it, and then to pick a stock that is highly correlated to the sector to backspread as described above.
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Old May 26, 2004, 10:02am   #4
 
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Hi RogerM

Just came across this thread and thought it was very informative. I had a similar idea (i think i did anyway ) a while back but not having looked at options too much or for a long time i was unsure of how it would or could play out. I can see from your clear explanation that this would be very workable indeed. At the time i was thinking more about a put/call spread but looking for a break out or reversal of s/r points.

I think i will give it some more thought and see what i come up with.

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Newtron Bomb

ps Still gliding? how was NZ?
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Old Jun 25, 2004, 10:42am   #5
 
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RogerM started this thread Hi NB - just been reviewing some options threads and am consumed with guilt at not having responded to your last. This project has been on the back burner for a while. Have you made any progress with it?

Not been gliding for a while. Very seriously considering getting back into hang gliding after a long lay-off. Performance has improved dramatically in recent years. Best L/D of 15:1 now even on good intermediate machines. NZ was fantastic - best 3 weeks of my life!
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Old Nov 11, 2004, 12:43pm   #6
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Quote:
Originally Posted by RogerM
This is an idea that was spawned by a posting on elitetrader.

For those that have come up against resistance, place a call backspread (i.e. with stock at (say) 98, sell 1 x 100 call and buy 1 x 105 call). Max risk is 5 - the gap between the strikes. Likewise for those at support, place a put backspread (i.e. with stock at 102, sell 1 x 100 put, buy 1 x 95 put).

Any thoughts or comments?

RogerM, the spreads you have described are verticals (not backspreads). A backspred is net long gamma - or more simply, net long. The spreads you describe are neutral (long legs = short legs) and are short gaam (the ITM option is sold, with the OTM being bought for cover).
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Old Nov 11, 2004, 12:58pm   #7
 
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RogerM started this thread predator001 - many thanks for the correction. I have come across the term backspread to mean one of 2 things :-

1. a "vertical credit spread" where there are equal numbers of short and long positions, but where the short position is written so as to leave a net credit in the spread, or

2. the definition you give which is for there to be more longs than shorts - typically 2 longs paid for by one short - so that the position is, as you say, net long.

It would appear that this is the more commonly used definition of a backspread and I may well edit the above post to call the position a "credit spread" to avoid this confusion. Thanks for your interest.
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