Options Trading Strategies - Approach

[janus]

Thought I'd ask a question of this forum on how folks approach their options trading.

Options open up a wide range of possibilities to make (and lose) money, not only on price movement but on volatility and time. There are many well documented options strategies, verticals, time spreads, straddles, diagonals, butterflies etc. which take advantage of these factors.

Rather than discuss the merits or workings of a particular options strategy I am curious to know how folks approach their options positions. From what I've read I pick up 2-3 themes (please add this is just my observation).

a) Find a setup (fund or tech) in the underlying and apply a strategy, then track exit rules (eg straddle on low IV with up and coming news events, or vertical on stock breaking resistance anticipating price move etc)

b) Adapt a strategy for trading a particular vehicle (eg I've heard quite a few folks selling strangles on the FTSE 100, front month so much out of the money etc)

c) Start with some view on the underlying but then adapt and modify position over time to reduce risk/lock in profits.

I guess c) is really the advanced form of a) or b). But it appears to me tracking the performance of a lot of options positions that to really make money one needs to be good at c).

I'd appreciate views and any insights folks are prepared to give on how they approach trading options and whether they've found my comment on c) to be true, or do you just use exit rules from the initial position.

P.S. If you're tempted to post something like 'options are complex and you need to understand them before trading' please don't. That is not the purpose of this question and it lengthens the thread without adding value.

 

[RogerM]

Hi Janus - welcome to T2W.

I tend to use all the approaches you outlined.

With a) I tend to screen for IV skews (high IV in near month and low IV in later month) and then look at these with a view to selling a calendar spread for a credit if I also like the look of the chart. I also like to write call backspreads on shares approaching resistance and put backspreads on shares bouncing off support.

With b) I tend to write a strangle on the ftse, but with a long put a couple of strikes below the short put strike so that in the event of a catastrophe I get to keep my home!

I tend to bring c) into play with all strategies, as i like to be near delta-neutral with credit strategies by selling/buying the underlying (futures for the ftse and stock for share options). I think you have hit the nail on the head when you say that c) is an essential skill to develope if you are going to stay in the game for the long term.

 

[janus]

RogerM,

Thanks for the reply. I'm pretty comfortable with strategies and when to apply them but can find less info on modifying positions, the when by how much, use of greeks etc. Most books mention it but don't give any clear worked examples of trades. Do you know any ?

I would be fascinated to see an example trade where you've adjusted to keep delta neutral and build up profits. Would you be prepared to share such and example ?

 

[RogerM]

Janus - when I have a bit of time later in week i'll be happy to oblige.

 

[charlesk]

Hi Janus - welcome to T2W.

I tend to use all the approaches you outlined.

With a) I tend to screen for IV skews (high IV in near month and low IV in later month) and then look at these with a view to selling a calendar spread for a credit if I also like the look of the chart. I also like to write call backspreads on shares approaching resistance and put backspreads on shares bouncing off support.

I've seen a few ppl now mention this "IV skew" kind of trading, and I'm somewhat confused or not sure about exactly what it is. This may be because the Oz options markets are different to the Uk, or that I just don't understand, I don't know. Please let me know if I've got this right...

You're looking at the implied volatility in the OPTIONS price. You might get a list of the IV for each strike price for each expiry month of an underlying stock. Then you compare the IVs for the same STRIKE price, but different months. If you see say $1.10 May Calls with a vastly different IV from $1.10 July Calls, then you might try to exploit that by assuming that the IV should come back to roughly the same?

What kind of volumes on the options being used to look at IV are there? For most of the Oz shares, their corresponding options probably don't trade too much more than 200 contracts a day per option. Is that enough to get a valid IV?

Any help, would be much appreciated. Also why use implied volatility and not just normal volatility?

 

[RogerM]

I've seen a few ppl now mention this "IV skew" kind of trading, and I'm somewhat confused or not sure about exactly what it is. This may be because the Oz options markets are different to the Uk, or that I just don't understand, I don't know. Please let me know if I've got this right...

You're looking at the implied volatility in the OPTIONS price. You might get a list of the IV for each strike price for each expiry month of an underlying stock. Then you compare the IVs for the same STRIKE price, but different months. If you see say $1.10 May Calls with a vastly different IV from $1.10 July Calls, then you might try to exploit that by assuming that the IV should come back to roughly the same?

That's the gist of it. But you need to understand WHY the IV is skewed like it is. Are there results imminent?

200 contracts a day doesn't sound like much liquidity, so whilst you'll get a figure for IV, not sure how valid it will be in the absence of a liquid market. I have no experience of Oz stocks or options so can't answer that one.

Also why use implied volatility and not just normal volatility?

Historical Volatility tells you what volatility has been in the past, based on the actual movement of price. IV is a measure of the level of price movement that MAY take place in the future - hence the increase in IV in the run up to results, and the fall in IV that often follows when those results prove to be a non-event.

 

[belinea03]

Charlesk,

Calendar sprd take advantage of the different rate of time decay between the front and back month options. Theta (time) decay in an option is greatest during the last 30 days leading up to expiration so it suits us to sell these types of options when appropriate. IV skews between the months (front and back) indicates that one option is more expensive - or overpriced - relative to the other. The usual strategy is therefore to sell overpriced front month options that looses value rapidly and hedge our position by buying a reasonably or underpriced back month option that loses value slowly.

There are two primary risks with this strategy: first, the price of the underlying moves outside our breakeven points (that why we prefer a non-trending stock or at worst a stock whose future price can project with some degree of "acuracy"; second, IV reduction in the option we own (this will cause it to lose value). These are two of the considerations when designing this strategy.

There are a host of different types of calendar strategies, for example, double calendars using calls and puts, split strike calendars, diagonals, double diagonals, reverse calendars and ratio calendars to name a few. Calendars can be combined with other spreads to create modified strategies, e.g., calendar + vertical = diagonal. Knowing these strategies helps in taking advantage of market conditions or saving trades gone/going bad.

Finally, we focus on IV instead of statistical (historical) volatility because the former relates directly to the price of the option. SV relates to price movement in the underlying.

I hope this answers your question.

 

[RogerM]

Janus has politely reminded me that I have yet to follow up my promise to post on Delta Hedging.

Having thought this through, I think the best place to start would be to watch the tutorial on the subject on Peter Hoadley's excellent options site. The latest version of the option modelling software includes the ability to automatically hedge a single option or a strategy involving multiple contracts. This is covered in the "automatic position hedging demo" under the enhancements listed for 1st May.

http://www.hoadley.net/options/LatestVersion.htm

The ability to use the delta hedging tool is still included in the free version of the software, and anyone interested in the subject should download and use it provided they have an up-to-date version of Excel. The latest automatic position hedging tool requires the Excel Plug-in at a cost of $55 Aus, or about £22.

When you watch the demo, you will notice that as the position becomes more and more hedged, so the potential profit reduces. Ultimately, when the position is fully delta, gamma and vega hedged, virtually all risk has been removed from the trade, as has nearly all the profit! But the hedging does allow you to amend the risk inherent in any position to a level with which you feel comfortable. If that level is nil then so will be the profit, in which case perhaps options trading is not for you.

I hope this isn't seen as a cop-out. The demo does show a real world trade amendment.

 

[osho67]

Dear Roger
Thanks for your post. I am struggling to understand Greeks but cant find simple easy to understand tutorial. You might be able to help. I even bought Natenberg book but it is on a very advanced level and cant understand much. As you know I write covered calls and sometimes naked puts and when I read on ET that some make 8-14% per month my enthusiasm fired and I would like to become an advanced option trader but donot know how to go about it. Somehow I have ti master all greeks and volatility. All help much appreciated.

 

[momoney]

if you go onto www.liffe.com there is a link to optioneasy

it lets you for a given strategy do simulations, and plots results and pnl

it lets you customize horizon also

 

[RogerM]

Dear Roger
Thanks for your post. I am struggling to understand Greeks but cant find simple easy to understand tutorial. You might be able to help. I even bought Natenberg book but it is on a very advanced level and cant understand much. As you know I write covered calls and sometimes naked puts and when I read on ET that some make 8-14% per month my enthusiasm fired and I would like to become an advanced option trader but do not know how to go about it. Somehow I have ti master all greeks and volatility. All help much appreciated.

osho - there is no easy answer to your question. It is true tho' that to progress with options you do really need to have a working knowledge of the greeks - esp delta and gamma - if you are selling options in particular. Delta will tell you how much an option price will move for a unit price move in the underlying, and is therefore important in understanding how much your position is at risk if the underlying moves against you, or how much you may profit if the underlying moves in your favour. Gamma tells you how delta will change for any given move in the underlying. Everything else being equal, Gamma tends to increase as you approach expiry, which can lead to very rapid and wild changes in option value in the run up to expiry. A working knowledge of gamma can enable you to anticipate these opportunities and risks. It will also enable you to hedge the position to keep risk to a level with which you feel comfortable. (or perhaps more accurately - to a level at which you no longer feel excruciatingly uncomfortable!)

I can only suggest that you read as many different texts as you can and eventually the "penny will drop". Ultimately you will find a text that you can relate to. I agree that Natenberg is not an easy read, which is why I only recommend it as a follow up to a decent options primer, but I think he does explain complex issues very clearly, and it is the bible of many of the options floor traders.

8% - 14% per month is certainly achievable, but no one ever said it was easy or risk free!

 

[gbr128]

"All things being equal, Gamma tends to increase as you approach expiry"

Gamma will rise sharply for at-the-money options approaching expiry, but will fall away sharply for either in-the-money or out-of-the-money options. There's a chart in Natenberg which shows this along with many others which are really useful for understanding the sensitivities an option's price has.

And if you're writing options you'll have negative gamma...

 

[RogerM]

Thanks gbt128 - spot on! Just goes to show the danger in bashing out a quick answer without looking at it from all perspectives. The message that I was trying to get across is that as you get near to expiry, options that are near the money or ATM will see their values change increasingly dramatically with a small move in the underlying, as a result of gamma (either +ive or -ive - i.e. gamma moves increasingly away from zero).

 

[Robertral]

Thanks gbt128 - spot on! Just goes to show the danger in bashing out a quick answer without looking at it from all perspectives. The message that I was trying to get across is that as you get near to expiry, options that are near the money or ATM will see their values change increasingly dramatically with a small move in the underlying, as a result of gamma (either +ive or -ive - i.e. gamma moves increasingly away from zero).

Can you give us more details on the above please????
Does any one know the closed form solution for the gamma hammer???? is it the 3rd derivative of vomma with respect to kabanger????

 

[kvhutch]

Calendar Definitions

"...There are a host of different types of calendar strategies, for example, double calendars using calls and puts, split strike calendars, diagonals, double diagonals, reverse calendars and ratio calendars to name a few ... "

Hi Belinea03 (or anyone else who can help)

Reading through this board recently I came across your very interesting post. What I was most interested in was your listing of the various types of Calendar Spreads. Some I know, others I've had a pretty hard time tracking down (though I'm sure what they are is implicit in their given names). I'm wondering if some of them are proprietary names(?)

In particular I can't seem to track down a definition of a 'Split Strike Calendar' or a 'Double Calendar'. If you (or anyone) can point me in the right direction as to where I can get this info -or even supply the briefest of descriptions I'd be much obliged. Thanks and take care

kvhutch

 

[Robertral]

"...There are a host of different types of calendar strategies, for example, double calendars using calls and puts, split strike calendars, diagonals, double diagonals, reverse calendars and ratio calendars to name a few ... "

Hi Belinea03 (or anyone else who can help)

Reading through this board recently I came across your very interesting post. What I was most interested in was your listing of the various types of Calendar Spreads. Some I know, others I've had a pretty hard time tracking down (though I'm sure what they are is implicit in their given names). I'm wondering if some of them are proprietary names(?)

In particular I can't seem to track down a definition of a 'Split Strike Calendar' or a 'Double Calendar'. If you (or anyone) can point me in the right direction as to where I can get this info -or even supply the briefest of descriptions I'd be much obliged. Thanks and take care

kvhutch

Well just from the name I can imply that a "Split Strike Calender" is a diagonal spread, i.e one 4625 Nov Call against a 4775 Dec Call.

I can only assume that "Double Calender" is a call in one month with a put in another month with the same strike (double means straddle), i.e nov 4625c all + a dec 4625put

Helps???

 

[kvhutch]

Well just from the name I can imply that a "Split Strike Calender" is a diagonal spread, i.e one 4625 Nov Call against a 4775 Dec Call.

I can only assume that "Double Calender" is a call in one month with a put in another month with the same strike (double means straddle), i.e nov 4625c all + a dec 4625put

Helps???

Yep, you've confirmed my suspicions. Many thanks for that.