Hedged strategy using UYG/SKF Financials. What do you think?

[JJacksET4]

Here is a strategy I have been thinking about using the Ultra Financials ETFs UYG and SKF (SKF is the Ultra Short).

For those who aren't aware, UYG tracks Financials, but is designed to change at double per day what the index does, and SKF is designed to change double the inverse of Financials. As far as I can tell they move pretty correctly respectively (i.e. do a chart on Yahoo In UYG and compare it to SKF - you can see every time one goes up, the other is down about the same amount).

Here are some current facts about the prices, etc. as of today:

SKF close = 244.12
UYG close = 3.98

Here are some options I will be using in this example. You can see them on Yahoo. Hopefully my info is correct, but if not, maybe someone can point it out.

SKF Puts - 200 Dec - 3660 bid
150 Dec - 1650 ask

UYG Calls - 4 strike Dec $110 ask

Before I mention the strategy here, let's compare UYG and SKF using past closing price info. Remember right now UYG is just under $4 and SKF is $244.12.

13-Nov-08
SKF = 148.60
UYG = 7.50

4-Nov-08
SKF = 110.73
UYG = 10.94

17-Nov-08:
SKF 180.54
UYG = 6.05

26-Sep-08:
SKF 96.33
UYG 20.26

Here is the strategy:

Sell a 200/150 bull put spread on SKF - get $2000.
Max risk = 5000-2000 = $3000.

Max risk at expiration on the SKF position only if SKF below 150.

Buy 18 - 4 Strike UYG calls $110 each - $1980

If SKF>200 then all options expire worthless. This is if financials
remain low. No matter how low they go, no loss is incured in this trade. The good news here would be that you could have made money if financials soared, but not get hurt if they actually tank in Dec.

IF SKF=150, UYG should be about $7.50 (based on Nov 13th close) Each 4 strike call = $350 or $6300 total.

IF SKF = 110, UYG should be around $10-$11
based on Nov 4. Each 4 strike = $650, or $11700 total.

If SKF = 90 or less, UYG could go over $20 based
on Sept 26th, etc. Each 4 strike would be $1600,
or $28000+

So, the idea is that hopefully financials would rebound and your gain on the 18 4 strike calls for UYG would blow away any loss on the bull put spread on SKF. However, it is hedged in that if financials continue to fall, all options would expire worthless and you could try again later.

Notes:
SKF has reasonable premiums up until the very end, so you have
to watch it closely as expiraton approaches.

If Financials rally and UYG soars early on, you could close that position and keep SKF pos open if desired, incase financials then fell back and SKF hit Dec expiration at >200. Best of both worlds would be UYG going to say $10/SKF under $150, sell UYG calls for $600 each or $10,800 total, hold SKF, then SKF rebounds to over $250 and bull put spread expires worthless.

Remember - the SKF Position can only be $5000 against you no matter what, of course, you wouldn't want to trade more then you could afford to.

Possible Adjustments:

If you don't like the fact that if financials fall, you make no money
(even though there is also no loss), you could consider:

Buy 15 calls intead of 18 and thus get about $400 credit. However, this could turn overal position into a small loss if SKF goes to 150 and UYG = 7.0 or so.

Could consider buying 15 calls and 100 shares UYG. Then, even if
SKF soars to 500 and UYG goes to $1, once DEC expiration hits,
you have 100 shares of UYG free for what it's worth.

Possible issues:

If SKF/UYG don't track each other close enough. However, this seems unlikely as they have tracked each other quite closely in the past.

If SKF went to 150 and UYG wasn't quite 7.0, you could take a small loss. For example if UYG was only at $6.0, each call would be $200, which is $3600 total. However, remember that you could probably close out the SKF position for less then $5000 at this time as well , if you weren't right at expiration, so there may not be much of a loss if any. Also, just about any additional upmove in UYG would help more and more at that point.

IV - IV isn't as much of a factor IMO as movement of the ETFs. You need UYG to move in the money and the spread against you in SKF is limited no matter what SKF does. IMO IV moves aren't likely to be the deciding factor in making money in this.

SKF and UYG both seem fairly liquid with decent Bid/Ask spreads, but SKF spreads are a bit bigger. SKF options are very expensive as it is a high priced ETF and has huge moves.

Is there anything I'm missing here? I realize it's not a perfect trade, but it makes sense to me because partly because on one side you are limiting the damage by using a spread, but on the other side you are letting profits run by just having the calls. Also, the fact that you are using options with Ultra ETFs gives the possibility of strong moves. Can anyone shoot a hole in this trade to show where it is doomed to fail?

This is of course different, but could be similar from trading an ETF and a stock in a pair. For example, you could go long UYG and short GS for an example. The issue there is that you are betting on financials to out perform GS, which may or may not happen. With a trade just involving UYG/SKF, you aren't looking for one side to do "better", you know that one side up means the other will go down and you are just trying to capitalize on the fact that you can limit losses on one side and let gains run on the other side.

I haven't studied these in as much detail, but I think a person could try the same thing with DIG/DUG (energy 2x ETFs). Also, there may be other market Ultra ETFs a person could use, but you have to make sure they are liquid ETFs, etc.

Of course, this is NOT A RECOMMENDATION!, but just to make a record of it and see how it does, I will paper trade this here using Friday's closing prices, assuming I could have got these on Fri near the close if I had put the orders in:

Sell 1 SKF put 200 strike - SKDXR.X (DEC) - $3660
Buy 1 SKF put 150 strike - SKFXY.X (DEC) - $1650
Net = +$2010

Buy 18 - UYG calls 4 strike - UUFLD.X (DEC) - $110
Net = -$1980

Net credit = $30.

I'll track it and see how it does.

JJacksET4

 

[spindr0]

Ya know, people like you make my head hurt (g).

Interesting SKF/UYG premise. For now, I just want to comment on your UYG/GS pairing. In the long run, in order for pairs to work, you have to be lucky or have an edge. Luck is fine for positions here and there but eventually, the law of averages will take care of that if you do enough of them.

What makes pairs work is the edge. I trade pairs heavily - I've found an edge in an illiquid sector. Without it, you're just flinging trades at the wall- like being in a bar late at night, hoping to get lucky (g).

I apologize in advance for stating this without be willing to provide precise details because I don't need the competition. Alas, that may make me sound like your typical investment BB A-hole spewing success stories. But this isn't about me (wink)... at least until subsequent abusive replies to me (g).

With my pairs, there's a common bond that links the components (yield). With an understanding of which candidates are over and undervalued, I'm able to shuttle in replacements. To be more specific, my initial position is based on selling an overvalued component and buying an undervalued component. As a general rule, the stock sold has a higher price than the stock bought.

Whether they go up or go down is irrelevant to me. I'm concerned with the spread b/t the two, not the direction. Ideally, I'd like my longs to go up and my shorts to drop (the bar scene again?). That happens but not very often. Because this is a regression to the mean issue, I'm more interested in the narrowing of the spread. If that happens, BINGO, there's the profit. If it doesn't but price movement has occurred, that means that one side has gain while the other a loss. If my gain isn't as much as my loss, I'll book that gain and substitute another over/undervalued leg for it.

IOW, if both legs of my pair rise but the short loss exceeds the long gain, I'll book the long gain and replace that leg with a more undervalued, hopefully lower price long leg, hoping, errrrr, waiting for that new spread to narrow. Conversely, if both legs of my pair drop but the long loss exceeds the short gain, I'll book the short gain and replace that leg with a more overvalued, hopefully higher priced short leg, hoping for that new spread to narrow. Sooner or later it does and the paper loss is reduced and sometimes even eliminated. Once in awhile, a thing of beauty occurs - you get a price inversion where B was replaced by C (C was lower priced) and then B drops below C, allowing the substitution to be repeated, booking more gains.

This is a dynamic process. It can go on for weeks and even months as I continually book more gains than racked up paper losses. And the pairs can mutate into multiple legs where I have more than one component comprising one side.

Because it's a pairs strategy and is fairly well hedged, I have been able to take on much much larger positions than if I was purely directional. In the past six months, there has been only one day where the band widening (the spread difference) expanded to such an extent that it stressed my stop loss limit. EXTREMELY stressed it. But due to some luck, by the time I decided to start scaling it down, a reversal began and my intraday loss contracted back within the realm of comfortable tolerance.

There are multiple aspects of this process. When possible, I try to capture dividends on the long leg but have to be careful to avoid having a short leg going ex div. And then there's the issue of borrowability. It goes on and on.

If you study something long enough and find a tradeable pattern that has decent consistency, a pairs strategy can be very profitable yet lower in risk. This is essentially what you have posited as a possibility in your UYG/SKY and GS examples. Keep the faith!

 

[JJacksET4]

spindr0,

Thanks for the reply.

I understand what you are saying, but I have yet to find for myself what indicator or price change movement, etc. that I could use consistantly for a consistant edge. Maybe I need to check out high yielding stocks more.

Of course, the UYG/GS trade was just an example - I currently have no opinion on how GS will do compared to UYG. I could imagine either scenario of GS falling victim to the finanical mess and dropping like a rock, or if financials stabilize somewhat GS could benefit as a flight to quality stock, etc.

I think there are some threads on pairs trading here on ET that I should review again. What I usually find is people trading things like MACD, stocktaskics, etc which never seem to quite work right for me. It is also hard for me to try very short term trades such as day trades because of work.

If you don't mind, could you give any more details on how you know if a certain stock is overpriced? For example, I have long felt DECK or AZO were overpriced compared to similar stocks, but for a while they held up in value quite well until the market tanked. Maybe you have found a good way to judge a stock as overpriced relative to a sector, but often I have seen that a stock that seems overpriced can remain so for a long time. Of course, I can understand not giving away any big secrets!

In your post, I really like the statement "Because it's a pairs strategy and is fairly well hedged, I have been able to take on much much larger positions than if I was purely directional."

This is a very valuable thing for people to learn if they haven't. While a person might only want to risk say $1000 going pure long or short, they could feel and be just as safe with maybe $4000-5000 hedged and actually be in a position to make more money in a good move in the direction they anticipated anyways.

JJacksET4

 

[spindr0]

JJacksET4

I understand what you are saying, but I have yet to find for myself what indicator or price change movement, etc. that I could use consistantly for a consistant edge. Maybe I need to check out high yielding stocks more ...

If you don't mind, could you give any more details on how you know if a certain stock is overpriced?

Uh huh, that's what I need... competition for illiquid stocks

I think there are some threads on pairs trading here on ET that I should review again. It is also hard for me to try very short term trades such as day trades because of work.

Do a web search on pairs trading. There are a lot of approaches. I'll post a link or two for entertainment. They're not what I do but they give some ideas of possibilities. Your inability to trade intraday is a problem because throughout the day, the bands expand and contract. It's this movement that provides a lot of the action. 10 or 20 cents may not seem like much but when you scalp 500-1000 share trades, they can add up quite nicely.

If you don't mind, could you give any more details on how you know if a certain stock is overpriced? For example, I have long felt DECK or AZO were overpriced compared to similar stocks, but for a while they held up in value quite well until the market tanked. Maybe you have found a good way to judge a stock as overpriced relative to a sector, but often I have seen that a stock that seems overpriced can remain so for a long time. Of course, I can understand not giving away any big secrets!

The only thing that I can offer is that you want to figure out how to value similar stocks - eg. same sector. While it may be possible, I have no idea how one would determine a relationship b/t a tech stock and a medical devices stock.

Yup the hedged component is huge. I would have never imagined myself carrying a 20-25 thousand share position for days on end, given my Sunday school marm risk tolerance (g).

http://luminouslogic.com/a-pairs-trading-example.htm

http://www.traderslog.com/trading-pairs.htm

 

[upanddown]

I think the premium for SKF puts is way to high. I covered most of my shorts Thursday and started shorting SKF at 295 and buying large blocks of 15 and 20 june UYG calls

 

[spindr0]

Jacks,

Regarding your SKY/UYG spread, IV could play a large factor in the result. With the spread,
to a large degree, what you make on one side will be lost on the other. But with the long UYG calls, there's no offset. If IV contracts prior to expiration, you're going to lose a chunk of premium and that could affect your P&L as well as your possible adjustments. On an expiration basis, this would be irrelevant since you'd be dealing with intrinsic vlue, if any.

If the components of each are the same, correlation should be good going forward. I'm not familiar with ETF's so I don't know what the components are or if/how changes are made. If they're the same, they should correlate well. A thought for consideration: What would happen to each if a component went bankrupt and a reversal occurred?

While it's a bit of work, you might consider capturing some of the historical option prices
and model your theory. Yeh, yeh, past performance is no guarantee, etc. but it might give you a better feel. Another idea might be to set up some positions in a trading simulator.

I don't know how viable the trade is but it seems well thought out and you have a good grasp of the what ifs as well as possible adjustments. Track it and let us know how it goes.

Spin

 

[JJacksET4]

Quote from spindr0:

Jacks,

Regarding your SKY/UYG spread, IV could play a large factor in the result. With the spread,
to a large degree, what you make on one side will be lost on the other. But with the long UYG calls, there's no offset. If IV contracts prior to expiration, you're going to lose a chunk of premium and that could affect your P&L as well as your possible adjustments. On an expiration basis, this would be irrelevant since you'd be dealing with intrinsic vlue, if any.

Spin, yeah I thought about that part a bit. The UYG side is really dependant I think on the intrinsic value of the 4 strikes IMO. If UYG stayed around 4, those would lose value and even if it went up somewhat they may not gain much as expiration approached. For the UYG side to really do well I think you would need UYG going up enough to make the 4 strikes quite profitable, which I think is very possible IF financials rally, which admittedly might be a big IF. I really set this up to be an attempt to profit if UYG goes over say 6.50 or so, but still be fairly hedged if it doesn't. If UYG does go over 6.50, IV shouldn't be much of an issue then.

If the components of each are the same, correlation should be good going forward. I'm not familiar with ETF's so I don't know what the components are or if/how changes are made. If they're the same, they should correlate well. A thought for consideration: What would happen to each if a component went bankrupt and a reversal occurred?

The main UYG components can be seen easy enough from the Yahoo quote by going to the holdings page. For SKF it isn't very clear, but these ETFs are both from the same company and I think they correlate very well. AIG is listed as a component of UYG and I guess you could basically call them bankrupt. Of course, I think the components can change, but I don't think they do very often.

While it's a bit of work, you might consider capturing some of the historical option prices
and model your theory. Yeh, yeh, past performance is no guarantee, etc. but it might give you a better feel. Another idea might be to set up some positions in a trading simulator.

I don't know how viable the trade is but it seems well thought out and you have a good grasp of the what ifs as well as possible adjustments. Track it and let us know how it goes.

Spin

Yeah, getting historical option prices is a pain, but I have seen some places you can buy them from that look OK. I have thought about getting a year or 2 worth and backtesting several different strategys, but haven't got around to doing so.

Thanks for your interest and your good information as usual. I will post how it is going here.

JJacksET4

 

[spindr0]

JJacksET4,

For the UYG side to really do well I think you would need UYG going up enough to make the 4 strikes quite profitable, which I think is very possible IF financials rally, which admittedly might be a big IF. I really set this up to be an attempt to profit if UYG goes over say 6.50 or so, but still be fairly hedged if it doesn't. If UYG does go over 6.50, IV shouldn't be much of an issue then.

Anything is possible. What has made pairs trading do so well for me (the financials) has been an extended bout of corporate and government incompetence. Who knows? Maybe they could run out of stupid pills and a huge recovery could occur. (snark)

Either way, your position is hedged and has good potential for gain and adjustment. But always remember that if something looks really good, there's always a scenario where it doesn't work. The trick is to recognize that before it bags you - something that is often easier said than done.

Historical option prices can be purchased but I've never seen them cost less than a kidney donation. Business Week used to offer free quotes but last I looked, they stopped. Might be worth a look to see if they have resumed. Here's another link that works. Nabbing the quotes is a bit tedious but at least they let you keep your kidneys (g)

http://www.crimsonmind.com/options/HistoryData.aspx

Well, off to suit up for the opening of the gambling channel!

Spin

 

[JJacksET4]

Update Market close Nov 24th:
SKF close = 173.99
UYG close = 5.06

SKF 200 strike put Dec (Short) = 58/59.90
SKF 150 strike put Dec (Long) = 24/25.90
Worst case to rebuy = $3590
Price if split bid/ask = $3400

UYG 4 strike call Dec (Long) = 1.55/1.70
18 contracts owned
Worst case to sell = $2790
If Sellable for $165 = $2970

Net value = Worst case = -$800
Net value = split bid/ask and get $165 = -$430

Commentary:

Despite the decent sized unrealized loss that is now showing up for this position, I think it is in pretty good shape, as the UYG calls have moved pretty well into the money. This will improve the Delta, meaning that more movement upward in UYG will help the UYG calls more and more. There is now $106 in intrinsic value for each 4 strike Dec UYG call.

Also, the Bull put spread would cost us more to close right now then it's worth intrinsically. In other words, if SKF closed at 173 at Dec expiration, it would only cost ~ $2700 to close, not ~$3500.

So, if finanicals continue to rally, the gains in UYG should start helping that side more and more, and if financials fall back, the SKF side should get better.

JJacksET4

 

[JJacksET4]

Quote from spindr0:


Historical option prices can be purchased but I've never seen them cost less than a kidney donation. Business Week used to offer free quotes but last I looked, they stopped. Might be worth a look to see if they have resumed. Here's another link that works. Nabbing the quotes is a bit tedious but at least they let you keep your kidneys (g)

http://www.crimsonmind.com/options/HistoryData.aspx

Spin

I'm not sure what a kidney costs these days.

I have found 2 sites that seems reasonable for Historical option quotes. I don't want to put the links in however as I haven't reviewed them in detail and don't want to unfairly be too mean or too kind. One site was about $50 for a year's worth of data, but in the one day sample I downloaded I found too many errors for my taste. Another site seems to have pretty clean data and is about $180 per year of data. To try alot of backtesting over ups and downs, I would probably want about 3 years, but I'm not quite ready to pay that much just for a bunch of data that I would then have to build a VB interface around. Maybe if they have a special sale someday.

It would be cool to image the possibilities though - it wouldn't be too hard to make a program where it would look just like the Yahoo options chains, but have another dimension to it that Yahoo doesn't have - you could pick the date that you wanted to see what the option chain would be. You could have Prev and Next buttons to go through each day. Of course, it could also be used for quickly trying things like ATM straddles on every DOW component or whatever and seeing what would have worked.

JJacksET4