Deep in the money call and put with stop losses?

[JackRab]

Why would you trade DITM if you can trade underlying?

Just put a market buy and market sell in the future or underlying at your stop level if you want to go the way you described.
Stoplosses on ITM options are shit, there's always a bigger spread and the possibility of no market at all. Liquidity is way worse than underlying... since it's derived from the underlying.

Then buy the OTM equivalent of your ITM strike if you want some sort of gamma/protection. Or buy the OTM strangle like @Martinghoul mentioned.

 

[HappyTrader]

Hey guys,

What if I bought a long deep in the money call and put kinda like a straddle, with a trailing stop loss?

the hope being the stop loss kicks in when the underlying takes its direction getting rid of the loss leg and leaving you with a profitable position.


Thanks.

If you BUY a call and BUY a put, you are spending a lot on premium.
If the underlying goes up, the put becomes less valuable.
If the underlying goes down, the call becomes less valuable.

Therefore, in the scenario where the underlying goes down and your trailing stop kicks in, you will suffer a loss on the CALL position. This will be offset to some extent by the gain in the PUT position. (All things equal, PUT/CALL parity should hold).

However, if this occurs any time after the purchase more than a day or so, the 'Time Value' of the option will also decrease. So you will suffer an additional loss on the value of the PUT option. Therefore the CALL/PUT may not cancel each other out perfectly.

For example:
Buy CALL @ 100$
Buy PUT @ 100$

Underlying drops. Call now worth 90$. You sell at 90$. However, PUT goes up in value, PUT now at 110$.

Total still worth 200$ (no profit).

But, if time passes, you could face:
Underlying drops. Call now worth 90. You sell at 90$. However, PUT goes up in value, PUT now at 105$ (instead of 110$ because less time value).

Total now worth 195$ (instead of 200$.

Therefore you suffer a loss.

Remember, there's no free lunch, you have to suffer a loss somewhere. The only question is what form is the loss and how much. So always find out how you loose money. If you can't find it, chances are you are missing something or you are a genius (or arbitrage opportunity that will be eaten away before you can click your mouse)

 

[Mattheweaston]

I would strongly suggest you read about put-call parity, to begin with... Then, as the next step, I would read about what's known as a "strangle". You can proceed from there.

And don't worry about "not one willing to let you out before expiration", as that's not how options work.

took a quick look at the put-call parity and correct me if I misunderstood the concept but the basic definition is one gain creates an equivalent loss, if a stop loss was in place on both sides ( assuming it did its job) would that not eliminate the the put call parity?

the strangle would need a bigger price move to see profitability, i guess the goal of my strategy would be to profit off a lower price move than a strangle

 

[Mattheweaston]

If you BUY a call and BUY a put, you are spending a lot on premium.
If the underlying goes up, the put becomes less valuable.
If the underlying goes down, the call becomes less valuable.

Therefore, in the scenario where the underlying goes down and your trailing stop kicks in, you will suffer a loss on the CALL position. This will be offset to some extent by the gain in the PUT position. (All things equal, PUT/CALL parity should hold).

However, if this occurs any time after the purchase more than a day or so, the 'Time Value' of the option will also decrease. So you will suffer an additional loss on the value of the PUT option. Therefore the CALL/PUT may not cancel each other out perfectly.

For example:
Buy CALL @ 100$
Buy PUT @ 100$

Underlying drops. Call now worth 90$. You sell at 90$. However, PUT goes up in value, PUT now at 110$.

Total still worth 200$ (no profit).

But, if time passes, you could face:
Underlying drops. Call now worth 90. You sell at 90$. However, PUT goes up in value, PUT now at 105$ (instead of 110$ because less time value).

Total now worth 195$ (instead of 200$.

Therefore you suffer a loss.

Remember, there's no free lunch, you have to suffer a loss somewhere. The only question is what form is the loss and how much. So always find out how you loose money. If you can't find it, chances are you are missing something or you are a genius (or arbitrage opportunity that will be eaten away before you can click your mouse)

This is how I see a profitable scenario

Underlying at 100
Call at 90, premium 12$ Stop loss at 11.75$
Put at 110, premium 12$ stop loss at 11.75$

Price gradually moves one way say to to 101 and the put stop loss get triggered losing .25

Sell call at 13 for a gain of 1$

Total gain of .75

Here are the risks I'm seeing
if the price see saws and triggers both stop losses, your going to have a bad day

If you don't take into consideration the bid/ask spread when choosing your stop losses, your going to have a bad day.

If you apply this as a day trade would that help eliminate theta?

 

[Martinghoul]

took a quick look at the put-call parity and correct me if I misunderstood the concept but the basic definition is one gain creates an equivalent loss, if a stop loss was in place on both sides ( assuming it did its job) would that not eliminate the the put call parity?

the strangle would need a bigger price move to see profitability, i guess the goal of my strategy would be to profit off a lower price move than a strangle

The point I was trying to make was that your position is, by construction, a strangle in the first place. Indeed, unless I am having a senior moment:
Long DITM call = long underlying fwd + OTM put
Long DITM put = short undelying fwd + OTM call
Hence:
Long DITM call + long DITM put = OTM call + OTM put, aka strangle

Put-call parity (assuming mostly normal mkt conditions, absence of dividends etc) holds regardless of stops etc. Obviously, it's only relevant if and when you have a position in a given option.

 

[HappyTrader]

This is how I see a profitable scenario

Underlying at 100
Call at 90, premium 12$ Stop loss at 11.75$
Put at 110, premium 12$ stop loss at 11.75$

Price gradually moves one way say to to 101 and the put stop loss get triggered losing .25

Sell call at 13 for a gain of 1$

Total gain of .75

Here are the risks I'm seeing
if the price see saws and triggers both stop losses, your going to have a bad day

If you don't take into consideration the bid/ask spread when choosing your stop losses, your going to have a bad day.

If you apply this as a day trade would that help eliminate theta?

I think there might be an error there. With DITM, Delta=1 (close enough).
Which means for every dollar increase in the underlying, the option price increases by 1$.

Stop loss = 11.75. This is a 0.25$ shift. Which means the underlying moved 0.25$.

So in your scenario, the PUT would be sold off at 11.75 when the underlying is at 100.25 (not 101).

Therefore the total gain would be 0$

(You might be sort of hoping to sell it at a stop loss of 11.75$ but the price keeps going up enough to sell for 13$ which might be optimistic).

 

[HappyTrader]

Btw, it also looks like you are trying to do two things at once, so to speak:

1) Deep In The Money Options -- Delta 1 -- This is usually done for leverage, rather than option trading (as the premium is rather large)

2) Option Trading -- Which is usually done with less expensive options so more can be bought/sold to take advantage of bigger swings.

Working with Delta 1s are cool and fun. But I think its best to consider them more of a stock replacement with leverage. So you would typically:
1) Go Long with the delta 1
2) Combine the delta 1 with purchasing a PUT for insurance (although at delta 1 you are already deep in the money so should have less concerns)
3) Simply set a stop loss on the delta 1 option if you are concerned about eating the loss (but a lot of people choose to roll over the option to avoid a realized loss).

Also note: At Delta 1, you are typically looking at leverage of only 3x. So if SPY is 100$ and you want Delta 1, you are probably paying 33$ or so for it (much more than the 12$ example).

As for working with pure option trading around SPY, there are a plethora of other strategies out there, most with a realizable loss I think your strategy most closely resembles a 4 legged combo:
1) Buy CALL 100, Sell Call 110
2) Buy Put 100, Sell Put 90

Combo 1 will profit you if the underlying moves above 100. But caps your profit to 110.
Combo 2 will profit you if the underlying moves below 100. But caps your profit at 90.

Of course, it has to make a move in either direction enough to make up for the cost of the premium (probably needs to move by 5$ in each way). If it doesn't, you loose premium (your risk).

But, before you do a combo like that you really *really* want to make sure you got your maths nailed and have tried out a few simulated runs.

 

[Mattheweaston]

Btw, it also looks like you are trying to do two things at once, so to speak:

1) Deep In The Money Options -- Delta 1 -- This is usually done for leverage, rather than option trading (as the premium is rather large)

2) Option Trading -- Which is usually done with less expensive options so more can be bought/sold to take advantage of bigger swings.

Working with Delta 1s are cool and fun. But I think its best to consider them more of a stock replacement with leverage. So you would typically:
1) Go Long with the delta 1
2) Combine the delta 1 with purchasing a PUT for insurance (although at delta 1 you are already deep in the money so should have less concerns)
3) Simply set a stop loss on the delta 1 option if you are concerned about eating the loss (but a lot of people choose to roll over the option to avoid a realized loss).

Also note: At Delta 1, you are typically looking at leverage of only 3x. So if SPY is 100$ and you want Delta 1, you are probably paying 33$ or so for it (much more than the 12$ example).

As for working with pure option trading around SPY, there are a plethora of other strategies out there, most with a realizable loss I think your strategy most closely resembles a 4 legged combo:
1) Buy CALL 100, Sell Call 110
2) Buy Put 100, Sell Put 90

Combo 1 will profit you if the underlying moves above 100. But caps your profit to 110.
Combo 2 will profit you if the underlying moves below 100. But caps your profit at 90.

Of course, it has to make a move in either direction enough to make up for the cost of the premium (probably needs to move by 5$ in each way). If it doesn't, you loose premium (your risk).

But, before you do a combo like that you really *really* want to make sure you got your maths nailed and have tried out a few simulated runs.

Awesome feedback this is mostly hypothetical right now as I haven't even begun to crunch the numbers to whether the risk to reward is worth it, ( still trying to establish all the risks and if they can be mitigated)

Looking at spy right now you you can buy a call with .99 delta for 7.76 premium with the underlying price at 216.15 that's over 20x but you're right that this is more of a leveraged trade than an options trade,

all this hinges on stop losses actually doing there job and the price clearly going one way, it's hard to paper trade whether the a stop loss will fail due to liquidity or slippage, I think I just have to take the plunge and let you know if it fails and why, and if it succeeds then i will say nothing

 

[HappyTrader]

May I ask which expiration date / strike you see a .99 delta for 7.76? There are a few things one wants to keep in mind here:

1) We are dealing with very low Implied Volatility right now (multi-year low), which means option prices are very low when buying. So this is not something you can repeat throughout the year. If you can, pull up some historic option prices to see what the leverage would be.

2) If it's a near term option it's possible that it does not move enough to make back the cost of the premium. (Time decay will cause the option value to drop faster than the underlying goes up).

3) Is the option actually being traded at that price? I've often pulled up quotes for options that have great prices only to find the liquidity is non-existent and could not be bought at that price.

Oh, and of course the more fun calculation (which is what the institutions are doing on their side) what is the actual risk premium rate of return on this trade versus a risk free (or low risk) trade. For example:


Underlying @ 216.15
CALL PRICE @ 7.76
STRIKE @ 208.50
Expiration: 31-01-2017 (Chosen to make it 6 months out)

If SPY @ 216.15 (flat) after 6 months
Exercise Option: Buy @ 208.50, Sell @ 216.15. Total Profit = 7.65 - 7.76 = -0.01

If SPY = 200 (drop) after 6 months
Option expires worthless (no reason to exercise and buy @ 208.50 when market price is 200)

If SPY = 220 (raise) after 6 months
Exercise Option: Buy @ 208.50, Sell @ 220. Total Profit = 11.50 - 7.76 = 3.74

But now we compare it to a 'Risk Free Rate Of Return'. If we take that at 1.7% on the 10-year bond:
Investment = 7.76
1.7% of 7.76 = 0.13192
Over 6 month period = 0.06596

Therefore the investment of 7.76 must return at least 0.06596 to be better than the risk free rate of return.
This means SPY must increase in value from 216.15 to 216.2159 (0.015% increase)

If general consensus is that S&P 500 will *NOT* raise by at least 0.015% this year (the consensus is it should drop a little form this 'high' point), then this would be deemed
a trade unlikely to be profitable.

This could explain why you see the option price low enough to get higher leverage. In other words: People are selling you cheap options because no one expects SPY to go high enough
for a profit to be realized.

Also, this is using the 10-year as a risk-free rate. You could also use different investments at a higher risk but higher return to measure the rate of return on this strategy. For example,
if you invested in high yield bonds or preferred or REITs, you could look at a return of 10% instead. In which case:

Investment = 7.76
10% of 7.76 = 0.776
Over 6 month period = 0.388

Therefore the investment of 7.76 must return at least 0.388. Which means SPY must increase from 216.15 to 216.538 (a 0.089% increase)

If you think the S&P 500 will increase by at least 0.089%, then this could be a profitable trade. Of course, if it drops it's not profitable

Also it is worth remembering: A delta 1 option does not stay delta 1 forever. As the expiration date approaches or the underlying moves the delta will change.

So some of the key risks are:

1) If there is a sudden drop (we hit 180), the option becomes worthless really quickly.
2) If we stay flat or low, the option value will decrease over time.

Delta 1 is great for leverage. But if it still doesn't budge, it doesn't matter how much leverage you got

 

[JackRab]

Here are the risks I'm seeing
if the price see saws and triggers both stop losses, your going to have a bad day

If you don't take into consideration the bid/ask spread when choosing your stop losses, your going to have a bad day.

If you apply this as a day trade would that help eliminate theta?

-1- correct
-2- correct, and this you can be certain of... you will cross the spread and likely at a bad level.
-3- no, theta is not an end-of-day thing, it's continuous. But when you look at delta 99, there's hardly any time premium, mainly intrinsic value

-4- high level of trading costs/fees...!!!!

So what are you trying to do? Ride a short term trend? Because buying DITM call versus DITM put, with both close to 100 delta.... you make nothing on the initial move... because there's almost no gamma in the position.
So... you stop out of one, let's say the put... then you want to ride the uptrend with the call for a while???