Option income strategies

Quote from akivak:

The problem begins when bear market comes – and in bear markers, very few newsletters deliver decent results.


Quote from spindr0:

Your iron condor is an indicator of market direction. Ignoring the 9/11 type of whacking, your iron condor is an indicator of market direction. If you see one side increasing in value and the other side idecreasing, isn't it obvious where your focus should be (management of existing positions and addition of new positions)?


Quote from akivak:

I don't care about the market direction, that's the whole point. As long as the market moves in any direction but not too strong, I'm okay.

I don't use newsletters for market recommendations so I accept your statement that the ones that you've perused/used have done poorly in bear markets. But you've missed the point.

Saying that you don't care about the market direction as long as the market moves in any direction but not too strong really is caring about market direction.

Since IC's have the potential to lose far more than the credit received (4:1 in your previous example), you should be concerned about market direction and act accordingly.

To repeat, your iron condor will tell you what you need to know, directionally. If one side isn't decaying into oblivion, it's a bit of a clue which direction the market is heading and where your focus should be. Adjustments can be made long before you get seriously into the loss zone - perhaps any of these or others:

roll the profitable side in (down for calls, up for puts)
add some more to the long leg on the problem side
reduce the short leg on the problem side
add the calendars you mentioned
roll out a month (same short strike distance or wider)
close it all down
whatever.
 
Quote from spindr0:

My experience with trading is that you run with whatever works for you. You bang out as many trades as you can handle for as long as you can but always remember that sooner or later it's going to bite you. Keeping that bite small is the key to it all.


Quote from akivak:

This is probably true for every strategy. But if you think the market will go up and it goes down by 10%, you lose 10%. Period.

Losing 10% on a single option position is not the end of the world. If you mean that the market went down 10% for the year and you lost 10% of your capital then again, you missed the point. Keeping the bite small means disciplined money management.
 
Quote from drcha:

You will not be able to stop this from happening in another 1987-style debacle. Your money will be gone at the open. Just another argument for insurance, but mostly, an argument for staying small.
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An 11/19/87 event will take your money away at the open. No question about it. But the prelude to it was a add'l 500 pt drop from Aug thru Black Monday and that was a serious warning to be short, hedged or out.

At that time, I was an option noob who had just graduated from covered calls to naked puts (snark on the synthetic equivalence). I didn't know squat about selling stock short, spreads, hedging or money management. I got hammered that day and amassed a full portfolio of stocks pretty quickly. But fortunately, the end of year was strong and I if my recollection is correct, the DOW ended not far from where it began that year. WHEW!

That day precipitated my learning about hedging and money management. Subsequent market cracks never did that to me again. Cracks take money away but I learned the hard lesson that you have to have to "protect your cities" in order to stay in the game. Profits will (almost) take care of themselves. Losses need all the attention.

As for trading small, I think one should trade no bigger what you can tolerate if the maximum loss occurs.
 
Quote from spindr0:

An 11/19/87 event will take your money away at the open. No question about it.

As for trading small, I think one should trade no bigger what you can tolerate if the maximum loss occurs.
More...

I think we all agree that the key to successful trading is risk management, no matter what strategy you use.
I would like to go into some details about my trading strategy and I would appreciate any feedback.

Currently, my strategy is the following portfolio allocation:
• 20-25% - two RUT IC diversified over time (front month and two months)
• 20-25% - three multiple calendars on three different index underlying
• 30-35% - stocks
• 5-10% - gold, options (calls/puts)
• 5-15% - cash

My rules for IC:
• Underlying: RUT (the most liquid, good premiums).
• Time to open: 6-8 weeks before expiration.
• Strikes: short strike about 1 SD from the current price.
• Credit: I usually aim for at least $1.0-1.2 per spread. This gives me risk/reward ratio between 1:4 and 1:3 (risk $7.5-8.0 to make $2.0-2.5).
• Exit: I usually close the whole trade when I have 20-24% profit OR when I can but back call or put spread for $0.20-0.25 OR 3-4 days before expiration. I’m trying to go to expiration weeks to avoid gamma risk.
• Adjustments: I start looking to adjust when the price is 10-15 points from my short strike. I might roll 20 points further out of money, buy straight call or put or just close the trade. All depends on time that passed market conditions etc. I usually don’t do more than 2 adjustments.

My rules for calendars:
• Underlying: MDY, SPY or any liquid index or ETF that trades above $100. The price is important commissions wise – with cheap underlying, the spreads are too cheap, you need more spreads and more commissions.
• Buy back month is 4-6 months, sell front month 4-5 weeks. 3-5 months is a compromise. The longer term options give less return on investment, plus they are les actively traded and bid/ask is wider. The shorter term (2-3 months) will require more trading, less opportunities to roll and more commissions and slippage.
• Buy ATM Calendar Spread, OTM Calendar Spread 1/2 of std deviation or more above the current price and OTM Calendar Spread 1/2 of std deviation or more below the current price. The risk curve looks like a circus tent.
• Adjustments: when the price hits one of the outside/wing strikes, then close the opposite side's calendar spread and open a new OTM calendar spread in the direction of the price move.
• Rolling: beginning of the expiration week. Sometimes I will roll earlier if the time decade of the next month becomes bigger than current month.

I’m still playing with different types of insurance. The options are (per 10 contracts RUT IC):
• Front month RUT put spreads 17-20% OOM (like 520-510 jan10 put spreads). Cheap, but protects only against “black swan” event.
• One straight put around 550.
• Mar/Jan put Calendar spread(s) around 550.

Any opinios?
 
I just read a very interesting article on Terry’s Tips website. Here are some extracts from the article.

Over a period of four decades, I have spent thousands of hours trying to devise the "perfect" option strategy using both puts and calls, a strategy that consistently made money in both up and down markets, one which would never give me a single sleepless night. I am absolutely convinced that the perfect option strategy just doesn't exist.
Part of me keeps hoping that is out there (and, yes, I keep looking for it every once in a while). But in my heart, I know that it could never be a reality – it would soon become public knowledge, and the market would make it disappear.

In order to make money with options, you absolutely must take some sort of risk. Generally, the larger the potential gain, the larger that risk must be.

Making adjustments can reduce risk, but not eliminate it entirely. Sometimes the market just moves just too fast to make the necessary adjustments. In the January 2008 expiration month, the Russell 2000 (IWM) fell 14.5%, wiping out much of the average 60% gains our portfolios had earned in 2007.

Admittedly, moves of this magnitude don’t occur frequently. Only once in the past 50 years had the market fallen by this amount (in October 1987). Of course, it fell by double that amount in the October 2008 expiration month, breaking all records for over 100 years. All of our portfolios lost money for that month.

The question for all of us to ask is "Are we willing to accept the risk of a dramatic market event that might take place only once in 50 or 100 years, knowing that we will lose a great deal of our investment if it occurs?" Can we live with this kind of risk if it means that we might be able to earn extraordinary returns in "normal" years?

Because an unusual event can be so devastating to most any option strategy (including the Mighty Mesa Strategy), surely any investor should only put a portion of their invested capital into one. You can take steps to reduce risk, but you can never eliminate it entirely.

That being said, there are several ways that risk can be mitigated.
1. Use indexes or ETFs rather than individual stocks as the underlying (since they are made up of several companies, they will not be as volatile). Our least risky portfolios are the broad-based SPY (500 large companies) and DIA (30 very large companies) and to a lesser extent (2000 small companies). Of course, the key is to find underlyings that have higher IV than the actual volatility that the stock demonstrates in reality. But as we know, predictions are difficult to make, particularly when they involve the future.

2. Roll out short options to the next expiration month a little earlier than expiration week. The tactic reduces the potential gains because you are not short the options during the week where most decay takes place, but it insures that your short positions have higher absolute values, something that considerably reduces risk of extreme volatility.

3. Place spreads over a large range of strikes, both above and below the stock price. The greater the range of strike prices, the less risk the portfolio has. The outlying strikes (those furthest from the stock price) tie up investment capital and offer minimal (on no) decay premium, but provide protection should the stock move in that direction.

Having short option positions at a wide range of strike prices means that you will have to make fewer adjustments (taking off some spreads and replacing them with others that are closer to the strike of the stock). Adjustments are costly in terms of transaction costs (bid-asked-spread-penalties and commissions), and almost always occur at the worst possible time (i.e., the spreads you are selling, those at strikes far away from the stock price, will have a relatively low value while those that you are buying (at strikes closer to the stock price) will be quite expensive.

4. Pair up a "bearish" portfolio with a "bullish" portfolio using the same underlying ETF.
5. Find an IV Advantage . When the IV of your long position is less than the IV of the short side, you enjoy an IV Advantage. It is easier to find bigger differences in IVs for individual stocks than it is for ETFs. While an IV Advantage is nice to have, it is not as important as other risk-reducing measures that can be taken.
 
Quote from akivak:

I just read a very interesting article on Terry’s Tips website. Here are some extracts from the article.

Over a period of four decades, I have spent thousands of hours trying to devise the "perfect" option strategy using both puts and calls, a strategy that consistently made money in both up and down markets, one which would never give me a single sleepless night. I am absolutely convinced that the perfect option strategy just doesn't exist.
Part of me keeps hoping that is out there (and, yes, I keep looking for it every once in a while). But in my heart, I know that it could never be a reality – it would soon become public knowledge, and the market would make it disappear.

In order to make money with options, you absolutely must take some sort of risk. Generally, the larger the potential gain, the larger that risk must be.

Making adjustments can reduce risk, but not eliminate it entirely. Sometimes the market just moves just too fast to make the necessary adjustments. In the January 2008 expiration month, the Russell 2000 (IWM) fell 14.5%, wiping out much of the average 60% gains our portfolios had earned in 2007.

Admittedly, moves of this magnitude don’t occur frequently. Only once in the past 50 years had the market fallen by this amount (in October 1987). Of course, it fell by double that amount in the October 2008 expiration month, breaking all records for over 100 years. All of our portfolios lost money for that month.

The question for all of us to ask is "Are we willing to accept the risk of a dramatic market event that might take place only once in 50 or 100 years, knowing that we will lose a great deal of our investment if it occurs?" Can we live with this kind of risk if it means that we might be able to earn extraordinary returns in "normal" years?

Because an unusual event can be so devastating to most any option strategy (including the Mighty Mesa Strategy), surely any investor should only put a portion of their invested capital into one. You can take steps to reduce risk, but you can never eliminate it entirely.

That being said, there are several ways that risk can be mitigated.
1. Use indexes or ETFs rather than individual stocks as the underlying (since they are made up of several companies, they will not be as volatile). Our least risky portfolios are the broad-based SPY (500 large companies) and DIA (30 very large companies) and to a lesser extent (2000 small companies). Of course, the key is to find underlyings that have higher IV than the actual volatility that the stock demonstrates in reality. But as we know, predictions are difficult to make, particularly when they involve the future.

2. Roll out short options to the next expiration month a little earlier than expiration week. The tactic reduces the potential gains because you are not short the options during the week where most decay takes place, but it insures that your short positions have higher absolute values, something that considerably reduces risk of extreme volatility.

3. Place spreads over a large range of strikes, both above and below the stock price. The greater the range of strike prices, the less risk the portfolio has. The outlying strikes (those furthest from the stock price) tie up investment capital and offer minimal (on no) decay premium, but provide protection should the stock move in that direction.

Having short option positions at a wide range of strike prices means that you will have to make fewer adjustments (taking off some spreads and replacing them with others that are closer to the strike of the stock). Adjustments are costly in terms of transaction costs (bid-asked-spread-penalties and commissions), and almost always occur at the worst possible time (i.e., the spreads you are selling, those at strikes far away from the stock price, will have a relatively low value while those that you are buying (at strikes closer to the stock price) will be quite expensive.

4. Pair up a "bearish" portfolio with a "bullish" portfolio using the same underlying ETF.
5. Find an IV Advantage . When the IV of your long position is less than the IV of the short side, you enjoy an IV Advantage. It is easier to find bigger differences in IVs for individual stocks than it is for ETFs. While an IV Advantage is nice to have, it is not as important as other risk-reducing measures that can be taken.
More...
terry has a history. he blew up bigtime a few years back. do a search on et.
 
Quote from vhehn:

terry has a history. he blew up bigtime a few years back. do a search on et.
More...

I know. He doesn't hide it. Even in this article, he mentions that "In the January 2008 expiration month, the Russell 2000 (IWM) fell 14.5%, wiping out much of the average 60% gains our portfolios had earned in 2007."

But he has many valid points.
 
I think that everyone agrees that risk management is the key, but I guess the key question is put very well by Terry:

“The question for all of us to ask is "Are we willing to accept the risk of a dramatic market event that might take place only once in 50 or 100 years, knowing that we will lose a great deal of our investment if it occurs?" Can we live with this kind of risk if it means that we might be able to earn extraordinary returns in "normal" years?”

I think in those strategies we don’t have to worry too much about even 10-15% moves – with proper management and adjustments, we can get breakeven or with small loss even in those months. The biggest concern is events like October 87 or October 08.

So let’s put some numbers. Let’s say I put 50% of my portfolio into those strategies and the rest cash. In “normal” months, it is not unreasonable to expect 10-12% return, or 5-6% on the whole portfolio. That’s 60-70% per year. When event like October 87 comes, we can expect to lose 60-70% - that’s 30-35% loss on the overall portfolio. Doesn’t it make sense to make 60-70% a year knowing that once in 10 years we can have a 35% loss? What am I missing?
 
Quote from akivak:

In “normal” months, it is not unreasonable to expect 10-12% return, or 5-6% on the whole portfolio. That’s 60-70% per year.
What am I missing?
More...

you really think its going to be normal to earn 60-70% a year selling premium?
 
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