Challenge and scrutinize this options strategy!

[manmi83]

Hi All,

I have been working on testing and perfecting this strategy for a few years now, ON and OFF periodically and can't for the life of me find a losing scenario over a 12-month or longer term period.

I'm thinking this can't be, so I'm turning to you guys if you can tell me if I am missing anything in this "too good to be true" strategy.

It's an options strategy that involves the following:

*Tested primarily on index etf's such as SPY,QQQ,IWM etc.
*Even tested the strategy for it's performance using an options simulator, however using real life historical prices for SPY along with appropriate volatility to get accurate option pricing into the simulation and period of test was 2007 July through 2009 February, during which the biggest drop occured and my strategy came up with a 79% return for the period mentioned, which annualized is 45% (this is net profit, after deducting commissions roundtrip).

Here is the strategy:

1.Buy deep in the money CALL option (approx. 30-35% in the money from current price) with an expiration of 1 year (LEAPS)
2. Buy a PUT option at the money with an expiration of 1 year also (LEAPS)
3. Every month, sell a CALL option At-the-money.

I have a few variations in mind, but let's start with the "basics" and hear your thoughts, please challenge it and say under what scenario this strategy would lose money during a 12-month or longer period time frame?

I am very analytical by nature, but have not found any glaring weaknesses in this strategy for producing +20% returns year after year, regardless of market direction.

Thanks for all your feedback in advance.

 

[ACstudio]

Ye that basically acts like a covered call at first that you have neutralized the Deltas by buying a put. It looks like to me that the put will be a drag on the position while the extrinsic value erodes over time while you pay fees to roll calls to maintain a delta neutral position.

Think of it this way....your deep ITM calls will be acting pretty much like stock as their deltas will be near 90. The short call and long put will basically bring that to near 0. It seems if you have a big enough move within one month or two you will have a difficult time rolling the short calls enough to maintain the neutral Deltas and at some point you will be losing extrinsic value on the puts.

The initial buying power reduction for doing this in the SPY is probably around 9-10k....this will also change each time you roll the short calls to a new strike. The long put will be fixed but it's deltas will change also but you will always be rolling the short calls to something like -45 deltas.

There isn't any free money out there...options in heavily traded markets are pretty efficient.

I would be more comfortable saying something like...If you have a bullish assumption on SPY then buy the LEAP call that has extrinsic value equal to the premium you can collect on the front month 1st out of the money short call....and just roll those until you either are profitable with your assumption....or if you are wrong until you can get out with a break even.

 

[manmi83]

Ye that basically acts like a covered call at first that you have neutralized the Deltas by buying a put. It looks like to me that the put will be a drag on the position while the extrinsic value erodes over time while you pay fees to roll calls to maintain a delta neutral position.

Think of it this way....your deep ITM calls will be acting pretty much like stock as their deltas will be near 90. The short call and long put will basically bring that to near 0. It seems if you have a big enough move within one month or two you will have a difficult time rolling the short calls enough to maintain the neutral Deltas and at some point you will be losing extrinsic value on the puts.

The initial buying power reduction for doing this in the SPY is probably around 9-10k....this will also change each time you roll the short calls to a new strike. The long put will be fixed but it's deltas will change also but you will always be rolling the short calls to something like -45 deltas.

There isn't any free money out there...options in heavily traded markets are pretty efficient.

I would be more comfortable saying something like...If you have a bullish assumption on SPY then buy the LEAP call that has extrinsic value equal to the premium you can collect on the front month 1st out of the money short call....and just roll those until you either are profitable with your assumption....or if you are wrong until you can get out with a break even.

Thanks for the reply ACStudio,

Here is the deal, the deep ITM LEAP call that I would be buying would have about 75-85 delta, and you are right the position mimics a covered call from the onset with a lower capital requirement of actually having to purchase the stock/etf, however I have tweaked it slightly instead of buying an ATM LEAP put option, I changed the put option to purchase at the exact strike price as the ITM call purchased with the same LEAP expiration period and still selling the ATM 1 month out call option. I have tested this strategy under three distinct environments: 2008 during which SPY dropped by 38.9% while the strategy produced over 100% Net of commission gains. Then I tested the same strategy under 2011 Beginning of March through 2011 end of February during which the SPY gained 47.1%, during which this strategy had gains of 30% net. So to me this proved that under a rapidly upwards/downwards moving environment, this will produce worthy gains but I had to test it under an environment during which the SPY would make practically no gains/losses and found 2011 beginning of Jan through 2011 end of Dec to fit such descriptions, where the SPY gained only 2% while the strategy produced gains of 18% Net of commissions.

Notice that from the onset the strategy is essentially a delta neutral strategy and sudden strong movements will indeed either erode the purchased call or put, producing temporary losses for the front months of the period, however once the impact of losses is increased, essentially strong moves upwards will turn the strategy into a delta positive (hence adapting) and in cases of strong moves downwards, the strategy will turn into a delta negative, once again adapting.

I do understand the old saying there are no free lunches and would like you and/or anybody else to give me a scenario where this strategy would be weakest and turn losses over a 12-18 month time frame overall.

I also realize that under certain circumstances there strategy may "under-perform" the market but that is not the point, the point is to deliver solid growth under any circumstance regardless of market direction.

Again your response/s are much appreciated.

 

[Windlesham1]

Are you using historical prices? Real time trading is a world apart and when rolling you may find front month vol is high,far month is low so any shorts will get ugly. I don't disagree with your strategy but you need to watch the relative vols, and liquidity in LEAPs. I have often posited simple strategies like buying £5k worth of puts when the market hits a high and maintaining modest theta will produce a killer profit very year based on the twice yearly drops-the problem is getting the right prices not only at entry,but at exit. Recently I've dipped out on about £90k worth of profits from a put trade that cost £1k-I made money but hundreds not thousands. Buy the market when VIX hits 24.Simples

 

[Windlesham1]

I'd like to price this but cannot get quotes for LEAP 30% out of the money-there's one problem

 

[options-george]

There isn't any free money out there...options in heavily traded markets are pretty efficient.

I completely second what ACStudio has said here. The only that retail traders should look to use options is as an alternative instrument for trading their directional bias, as protection for a position in the underlying or for earning some interest on an existing underlying position. There will be some other variants of such approaches (but those are the ones that come to mind right away).

You should not try to make money with options by looking for inefficient pricings!

I used to work with a market-maker for options and trust me, we spent a lot of time trying to price things correctly. The occasional limit order in the market was what we had for lunch!

 

[kbaker9247]

Options strategy

What happens if you sell a call at the money and the index goes up? Do you then buy back the call at a loss or do you close the whole position and open a new one at different strikes?

 

[Martinghoul]

The strategy is quite long fwd vol... This may or may not be a bad thing.