How do I make the most of this edge?

S

Sam Sanders

Let's assume I have a profitable long US equities signal that averages 2% profit over a 3-5 day holding period. The standard deviation of the trades is about 6% and tails are relatively thin (rare to see >20% gain or loss). Entry/exits are at market open. I've been profitably trading this system for over a year but was wondering if I can enhance my return with options.

My gut is that such a small edge, while great in equities, would be eaten up by bid/ask spread in options since the opening auction doesn't really apply. Is this a reasonable assumption? If not, how would you trade this?

Would you buy ITM calls, OTM calls, sell put credit spreads? Stock liquidity is all over the place but some have reasonable volume (1MM+ shares/day) and therefore should have a reasonable option market.
 
You can't trade options on the open or close and have any expectation of fair prices. There is no NBBO at open and the chance of noncompetitive prices are very high. You would have to change your timing to maybe 9:35am est for liquid options and later for those with wider spreads. No market orders.

1245
 
1245 said:
You can't trade options on the open or close and have any expectation of fair prices. There is no NBBO at open and the chance of noncompetitive prices are very high. You would have to change your timing to maybe 9:35am est for liquid options and later for those with wider spreads. No market orders.

1245
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That's what I figured, so at 9:35 what type of option trade should I put on?
 
wiesman02 said:
Sounds like long calls is what you want if you are hoping for a quick directional move up.
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Well I was hoping for a bit more involved answer. I know if a stock goes up, calls=good. But in my specific scenario (small expected profit), should I use ITM/ATM/OTM calls? I assume near expiry is best? Is a 2% rise in underlying even enough to offset transaction costs?
 
It would depend on the symbol and how much edge you are looking for. If you are looking for big moves, it will provide you will more leverage. If it's small moves, options spreads will eat you alive outside the liquid options.
 
Sam Sanders said:
Well I was hoping for a bit more involved answer. I know if a stock goes up, calls=good. But in my specific scenario (small expected profit), should I use ITM/ATM/OTM calls? I assume near expiry is best? Is a 2% rise in underlying even enough to offset transaction costs?
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Open up an option chain today and see high, low, current vs % change in UL and you will know.

Rule of thumb, OTM gives you a higher % return, ITM gives higher absolute return.
 
Sam Sanders said:
Let's assume I have a profitable long US equities signal that averages 2% profit over a 3-5 day holding period. The standard deviation of the trades is about 6% and tails are relatively thin (rare to see >20% gain or loss). Entry/exits are at market open. I've been profitably trading this system for over a year but was wondering if I can enhance my return with options.

My gut is that such a small edge, while great in equities, would be eaten up by bid/ask spread in options since the opening auction doesn't really apply. Is this a reasonable assumption? If not, how would you trade this?

Would you buy ITM calls, OTM calls, sell put credit spreads? Stock liquidity is all over the place but some have reasonable volume (1MM+ shares/day) and therefore should have a reasonable option market.
More...

Filthy just wrote an article addressing this very topic a few months ago in a now defunct trading magazine. He has an account here - perhaps if you PM him, he'll send you a copy. Personally, I have no doubt that you could improve your risk adjusted performance, but every time I've explored this the option bid/ask spread overwhelmed any perceived benefits.
 
It is a tradeoff among decay, volatility and slippage. If you use OTM calls, their value will decay quickly on a daily basis, which may offset your gains. If you use ATM calls, they jump around when volatility changes. If you use ITM calls, you have the purest way to duplicate the underlying, but the deeper in the money you go, the worse the bid-ask spread. You could use some combination of these, since each will perform differently under different conditions.

Personally, I like deep ITM calls and am willing to work with liquid underlyings that have minimal spreads. But that is just me--you have to do what suits your personality. I'd rather hit a single every week than stand around striking out a bunch of times waiting for the home run pitch.
 
not sure if you can successfully dupliate an equity strategy on options basis. probably ok for a few days, but if you hold it for two weeks, options premium decay will really eat your profits.
you sound like you just need more leverage. so rather go in that way.

CFD gives you 10:1 leverage, most US equities available (1500 with my broker). To open an account you must be non US or find a broker who accepts US clients or do some half-legal workaround on the US-restriction.
I recommend Interactive Brokers, but there are also a couple of good (but costlier) european brokers, like IG or ETX.

If that's not an option, SSF will do. Available for many US equities, giving you 5:1 leverage
 
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