fractional spreads

[Baozi]

Hello everybody,

I would like to write about a strategy that recently got my interest.

Basically it's just a bull/bear front spread, but instead of having the classic 2short:1long ratio it is more like 9:7 or 5:3, basically something less risky than 2:1 but also less conservative than 1:1. I'm not aiming at getting it for a credit, a small debit is fine.

I created a tool that scans all the possible combinations, and for each one spits out the risk/reward ratio and calculates the expected delta once the underlying price touches the short strike. (I assume delta of the short by then will be 0.5, and the long is derived by arbitrarily plugging in the moving average of the spot IV and half of the available days to expiration in the formula).

I will be basically picking the best trade-off between risk/reward and high delta.
Ideally, if the trade goes against me I will be losing a limited amount, if it goes in my direction instead, by the time it touches the short strike it will still have some steam(deltas) left. I will let it go just a bit beyond the point when delta reaches zero and starts inverting.

Now, my questions for the veterans of this forum are the following:

1-I will be combining this tool with entries from a trading system. I was thinking about using a mean reversion /failed breakout approach. Do you think this makes sense? Or should I use a trend following system instead?

2-What could be the worst case scenario in this trade? I am thinking about a spike in IV, where the stock suddenly blows past the short strike and the short losses are much higher than the long gains. What else could go wrong?

3-Which could be the best conditions to put on this kind of trade, in terms of IV rank and days to expiration?

4-What could be a reasonable profit target?

 

[TommyR]

if i close a trade and want to recalculate the next LOWEST in an unordered list without breaking and making the whole array from scratch what is the best way:if( arraysize==1){} ,if( arraysize>1){i_0 = arraymin(X), j=i_0, arraysize(X)=N, while(j<N){X[j]=X[j+1];j+=1} arrayresize(X,N-1, 10000), i_1=arraymin(X). seems complicated. the max is easy. maybe do the maximum of a function of the array but need no zeroes/poles so 1/(x+C) or something? does that answer your question?

 

[Baozi]

if i close a trade and want to recalculate the next LOWEST in an unordered list without breaking and making the whole array from scratch what is the best way:if( arraysize==1){} ,if( arraysize>1){i_0 = arraymin(X), j=i_0, arraysize(X)=N, while(j<N){X[j]=X[j+1];j+=1} arrayresize(X,N-1, 10000), i_1=arraymin(X). seems complicated. the max is easy. maybe do the maximum of a function of the array but need no zeroes/poles so 1/(x+C) or something? does that answer your question?

There are 3 possibilities:
1-you are trolling
2-you are a spambot
3-you are so much above my level that I didn't understand a single word.

In any case however, no, that did not answer my questions..

 

[tommcginnis]

Great looking test regime you're describing here.
I wish I had the time to follow it better, but I'm burning the candle at both ends now.
But (FWIW) I like the questions you're posing -- in my *cursory* understanding, they sound like you're shopping for advantage, wary-but-accepting of [any] loss, and aware of a possible cascade loss. (Which is the way to rules-based harvests, right? )
Hope to see more.

 

[sle]

Basically it's just a bull/bear front spread, but instead of having the classic 2short:1long ratio it is more like 9:7 or 5:3, basically something less risky than 2:1 but also less conservative than 1:1. I'm not aiming at getting it for a credit, a small debit is fine.

Just to make it clear, you are trying to find 1xN spreads that you'd like to trade? I am not certain what your evaluation criteria is (you do mention risk reward to delta, but it's unclear what your definition of "risk" is here).

1-I will be combining this tool with entries from a trading system. I was thinking about using a mean reversion /failed breakout approach. Do you think this makes sense? Or should I use a trend following system instead?

Well, think from the first principles. Your trade expresses the view that the realized distribution will be narrower than the implied distribution (that's why you are selling the N wings to buy the ats). What market environment does that imply?

2-What could be the worst case scenario in this trade? I am thinking about a spike in IV, where the stock suddenly blows past the short strike and the short losses are much higher than the long gains. What else could go wrong?

Your scariest scenario is that the stock gaps way past your breakeven. Chances are you not going to have any Vega exposure at those levels so IV is not going to matter that much. A jump in implied is going to hurt, but nowhere near as much as the stock move.

3-Which could be the best conditions to put on this kind of trade, in terms of IV rank and days to expiration?

It depends on the absolute level of vol and many other things (also, depends on the answer to my first question).

 

[Baozi]

Just to make it clear, you are trying to find 1xN spreads that you'd like to trade? I am not certain what your evaluation criteria is (you do mention risk reward to delta, but it's unclear what your definition of "risk" is here).


Well, think from the first principles. Your trade expresses the view that the realized distribution will be narrower than the implied distribution (that's why you are selling the N wings to buy the ats). What market environment does that imply?


Your scariest scenario is that the stock gaps way past your breakeven. Chances are you not going to have any Vega exposure at those levels so IV is not going to matter that much. A jump in implied is going to hurt, but nowhere near as much as the stock move.


It depends on the absolute level of vol and many other things (also, depends on the answer to my first question).

Hi, thanks for taking the time and effort to reply.


For the risk/reward part, I cannot evaluate the risk if the stock goes past the short strike as it is theoretically infinite, however I can take the max potential profit and divide by the cost of putting on the spread. That would be the first metric.
The second metric is that the delta of the longs must be able to "overpower" the delta of the shorts as much as possible. I expect that the peak of the profit curve will be at zero delta, so more deltas will likely extend the breakeven point.

These two metrics conflict with each other (if you add more shorts you reduce your cost basis, if you add more longs you add more delta), so in the end it will be a matter of choosing the best balance.

as for the system, if I'm trading mean reversion I know that my profit potential is limited, and on the other side I want to be protected in that 25% cases when there is no reversion..
to me it makes sense.. am I missing any elephant in the room?

 

[Baozi]

Great looking test regime you're describing here.
I wish I had the time to follow it better, but I'm burning the candle at both ends now.
But (FWIW) I like the questions you're posing -- in my *cursory* understanding, they sound like you're shopping for advantage, wary-but-accepting of [any] loss, and aware of a possible cascade loss. (Which is the way to rules-based harvests, right? )
Hope to see more.

Thanks for the support sir, appreciated.

 

[sle]

For the risk/reward part, I cannot evaluate the risk if the stock goes past the short strike as it is theoretically infinite, however I can take the max potential profit and divide by the cost of putting on the spread.

Overall, you might have too many variables to solve for. My suggestion would be to fix one and then use some sort of underlying-specific metric to understand the risk. For example, make them all costless by solving for the ratio at each different strike and then try to understand your max loss by looking at the stock history.

The second metric is that the delta of the longs must be able to "overpower" the delta of the shorts as much as possible. I expect that the peak of the profit curve will be at zero delta, so more deltas will likely extend the breakeven point.

Well, it depends - for example, if you are planning to hold them to expiration, you max profit is pinning the short strike and that's roughly 50 delta?

as for the system, if I'm trading mean reversion I know that my profit potential is limited, and on the other side I want to be protected in that 25% cases when there is no reversion..
to me it makes sense.. am I missing any elephant in the room?

If you are trading a 1xN spread (selling the N-leg) you are assuming that the actual distribution is gonna be tighter then the implied one - that means that you are expecting mean reversion in the underlying. My point was that you want to be consistent.

 

[Option_Attack]

If you have a decently profitable system why not try it with just long calls or puts? Simplify simplify, then semper fi! Stick with it a few trades. Some will be losers of course, but some will make a decent profit, and a few will make several times the losers.

 

[Baozi]

So.. I'm going back to my original post to write how things turned out for this fractional ratio strategy:

The most important lesson that I learned (the hard way, of course), is that the ratio can never be too steep. At the beginning I was thinking that 1:1.5 was fine, but the problem is that when the market goes past the short strike you are immediately losing money. The P&L curve won't bulge even a little bit, despite what you might think by looking at the terminal distribution. I held a 1:1.5 ratio until 7 DTE and with the underlying EXACTLY at my short strike.. and the P&L was still negative!!! (IV played a part as well, but still..) Now I understand why the "classic" 1:2 front ratio has such a bad reputation.

After the first failure I went with a second ratio, at 1:1.2 (10 longs and 12 shorts) and this time the results were much better, as the P&L went into the profit zone. I suppose this is because as long as the ratio is shallow the longs (which are further in the money) still have more deltas than the shorts.

I put on this trade around 50DTE, and I sold 1-2 extra shorts whenever the value went approx 20% above the starting cost, bought 1-2 extra longs whenever the value went approx 20% below. If at a debt, I never went more than 1% of available capital.

during its life (and its still living) the ratio went between 1:1 and 1:1.33. These would also be the points where the position is at its maximum risk, and also the points where the stock is most likely to run away, leaving you with a sub-optimal position, but as long as there is A) no excessive debt on the long side or B) excessive steepness on the short side, it can be managed without sweating too much.

When case A happened I covered all the shorts when they lost 80% of their value, then shorted again the same amount when the value went up a bit.

For case B, see the first paragraph, if it goes too far too fast I bet that the safest course of action is killing the whole structure while there is still some profit left. By modeling with an option analyzer I saw that the BE point slowly moves further out with the passing of time, so as long as it's not a meltup/meltdown it should be possible to hold longer.

I am still pondering over the following issues, any word of advice from the pros would be appreciated.

1)What would be a good time frame to put this on? I choose to put it on around 50DTE with the intention to slowly build up the position while time decay is still not a big concern. Consider that I can only choose 1month-2month-6month contracts because i play in the mighty chinese market.

2)What could be a good entry? Should I aim to enter on a reversal (therefore gaining from the shorts), or should I aim to capture a trending movement, as in a vertical?

2)What would be a good profit taking rule? Would you consider letting this thing run to expiration? would you take profits with a % rule? or with a time rule?

3)In a position like this, which are the second order greeks I should be afraid/aware of?