Had another productive weekend delving into some of the nuances of option strategies. As a result, my option strategy matrix is being revised.
My primary trading objective it to take a small amount of money and reliably turn it into a large amount of money. To do this, I need to find a trading methodology that has a consistent edge over time and does not place undue risk on my trading capital. Once consistent and competitive risk-adjusted returns are established, say after two years of proven results, I can look to manage other people’s money for fee income on a much larger capital base.
I am now going to substantially increase my account utilization for option strategies and hedge the various potentially unwanted risks that my account would now be significantly exposed to. Part of my risk management strategy is to diversify my trading instruments to include low correlation plays versus my otherwise primary hedging vehicle, MES. However, correlation can be subject to wide variance over my typical trade holding periods. I may be able mitigate this variance through an hedging adjustment based on my read of money flows and focusing on the lower correlated sector or industry ETFs rather than single named instruments. The following are risks that are subject to management:
Directional Risk (Delta) - All of my positions in my portfolio will receive a correlation or beta adjusted delta exposure value, basis ES. My current overnight net directional exposure allowance is 30 delta maximum.
Leverage / Daily Performance Risk (Gamma) - I wish to avoid a significant net negative gamma because of the potential of a large negative daily return and increased difficulty in maintaining a tight hedge on delta exposure. Therefore, this risk will be managed by using a multiple strategy approach.
Volatility Risk (Vega) - Risk here can go either way. In overall high volatility environments, the risk is volatility declining and resulting in lower potential future returns. In a generally low volatility environment, the risk is increasing volatility, thus likely stressing theta capturing positions. Therefore, in a high volatility environment, I will look to lengthen the holding period of the theta capturing part of my portfolio. In a low volatility environment, I will look to increase my use of calendar spreads, vertical debit spreads, and will more actively consider long option strategies.
Option Premium Decay Risk (Theta) - My net theta will generally be somewhat positive by forgoing potential additional gains on outlier moves in the underlying.
There appears to be considerable opportunity in single names, but I will limit exposure of any one equity as well as total single name exposure as a percentage of my overall portfolio.
The following are trading setups I will primarily be looking for:
1. Long calendar spreads of various duration depending on volatility levels and term structure. Primary metrics I will be looking for are net debit as a percentage of front month price and an inverted or at least flat term structure. Depending on my directional outlook, I will look to enter this trade at .25 to .50 delta basis the front month and prefer my debit is less than 33% of front month premium. This is a positive theta trade when placed in the delta range I have indicated.
2. Long Butterfly or Iron Condor Spread for Basis Reduction: I may use this strategy where a strong fundamental case may be made, but price may be “overextended” in the short term. This wide butterfly or iron condor will have the body near the current price of the underlying and wings at about the .024 / (.976) delta levels. As this wide trade entails more risk than others, I will adjust my trade size to account for it. Theta on this trade type is positive.
3. Long Butterfly Spread for Synthetic Position: I will have a well defined directional outlook here and want to benefit from higher leverage, tight defined risk, and a payoff profile that is more favorable than the underlying under a significant portion of the probability curve. This trade is to be structured so the one of the breakeven points nearly matches the current price of the underlying. The tradeoff to consider is when an extended move in the anticipated direction results in a loss instead of a outsized profit the underlying would enjoy. Generally, I will look to place this trade with one wing at about .65 delta, the body at roughly .40 delta, and the other wing at about .024 delta, or at about the two standard deviation level. Where there is a favorable term structure and I have reasonable confidence the chances of an extended move in the anticipated direction are low, a 1x3x2 structure will allow a potentially significant overall increase in probability of profit and improvement of other metrics.
4. Soft Overwrite (Hedged) or Covered Strangle: This strategy has a very high probability of profit and great flexibility in precisely dialing in one’s outlook. Issues to be aware of are potentially larger losses either to the upside or downside on extended moves. I will hedge unwanted deltas using MES. For capital efficiency and depending on other trade variables I could also buy a(an) .024 delta option(s). The key consideration is my net delta exposure and how much of it I want to keep. This strategy is mainly intended for ETFs.
5. Long Option: In a low volatility environment and a apparent change in the status quo in some metric, indicator, correlation, or Governmental policy, where a 2 standard deviation range expansion type move may be a reasonable target, I may take a shot, appropriately sized from a risk management standpoint, with a 1/42 chance of success based on static statistics. This type of trade will normally have a one day or intra week time stop associated with it. I would tend to go for very high positive gamma as would be seen with a Friday expiring option and thus would be subject to high theta decay, but a very favorable short term risk to reward ratio. My actual chance of success and potential for outsized returns may be much better than indicated by static statistics.
Another consideration is workflow efficiency and data visualization. I feel too much time is spent on looking for trading opportunities. Practice and a multiple monitor setup should go a long way to improve efficiency. For data visualization, I will set up a Black Scholes utilizing spreadsheet that will simultaneously compute and chart the metrics of interest under a range of time to expiration, moneyness, and volatility considerations for my various strategies. In addition, I will be able to more easily and effectively account for future term structure and skew assumptions in my trading decisions than what is currently offered on my trading platform.
My primary trading objective it to take a small amount of money and reliably turn it into a large amount of money. To do this, I need to find a trading methodology that has a consistent edge over time and does not place undue risk on my trading capital. Once consistent and competitive risk-adjusted returns are established, say after two years of proven results, I can look to manage other people’s money for fee income on a much larger capital base.
I am now going to substantially increase my account utilization for option strategies and hedge the various potentially unwanted risks that my account would now be significantly exposed to. Part of my risk management strategy is to diversify my trading instruments to include low correlation plays versus my otherwise primary hedging vehicle, MES. However, correlation can be subject to wide variance over my typical trade holding periods. I may be able mitigate this variance through an hedging adjustment based on my read of money flows and focusing on the lower correlated sector or industry ETFs rather than single named instruments. The following are risks that are subject to management:
Directional Risk (Delta) - All of my positions in my portfolio will receive a correlation or beta adjusted delta exposure value, basis ES. My current overnight net directional exposure allowance is 30 delta maximum.
Leverage / Daily Performance Risk (Gamma) - I wish to avoid a significant net negative gamma because of the potential of a large negative daily return and increased difficulty in maintaining a tight hedge on delta exposure. Therefore, this risk will be managed by using a multiple strategy approach.
Volatility Risk (Vega) - Risk here can go either way. In overall high volatility environments, the risk is volatility declining and resulting in lower potential future returns. In a generally low volatility environment, the risk is increasing volatility, thus likely stressing theta capturing positions. Therefore, in a high volatility environment, I will look to lengthen the holding period of the theta capturing part of my portfolio. In a low volatility environment, I will look to increase my use of calendar spreads, vertical debit spreads, and will more actively consider long option strategies.
Option Premium Decay Risk (Theta) - My net theta will generally be somewhat positive by forgoing potential additional gains on outlier moves in the underlying.
There appears to be considerable opportunity in single names, but I will limit exposure of any one equity as well as total single name exposure as a percentage of my overall portfolio.
The following are trading setups I will primarily be looking for:
1. Long calendar spreads of various duration depending on volatility levels and term structure. Primary metrics I will be looking for are net debit as a percentage of front month price and an inverted or at least flat term structure. Depending on my directional outlook, I will look to enter this trade at .25 to .50 delta basis the front month and prefer my debit is less than 33% of front month premium. This is a positive theta trade when placed in the delta range I have indicated.
2. Long Butterfly or Iron Condor Spread for Basis Reduction: I may use this strategy where a strong fundamental case may be made, but price may be “overextended” in the short term. This wide butterfly or iron condor will have the body near the current price of the underlying and wings at about the .024 / (.976) delta levels. As this wide trade entails more risk than others, I will adjust my trade size to account for it. Theta on this trade type is positive.
3. Long Butterfly Spread for Synthetic Position: I will have a well defined directional outlook here and want to benefit from higher leverage, tight defined risk, and a payoff profile that is more favorable than the underlying under a significant portion of the probability curve. This trade is to be structured so the one of the breakeven points nearly matches the current price of the underlying. The tradeoff to consider is when an extended move in the anticipated direction results in a loss instead of a outsized profit the underlying would enjoy. Generally, I will look to place this trade with one wing at about .65 delta, the body at roughly .40 delta, and the other wing at about .024 delta, or at about the two standard deviation level. Where there is a favorable term structure and I have reasonable confidence the chances of an extended move in the anticipated direction are low, a 1x3x2 structure will allow a potentially significant overall increase in probability of profit and improvement of other metrics.
4. Soft Overwrite (Hedged) or Covered Strangle: This strategy has a very high probability of profit and great flexibility in precisely dialing in one’s outlook. Issues to be aware of are potentially larger losses either to the upside or downside on extended moves. I will hedge unwanted deltas using MES. For capital efficiency and depending on other trade variables I could also buy a(an) .024 delta option(s). The key consideration is my net delta exposure and how much of it I want to keep. This strategy is mainly intended for ETFs.
5. Long Option: In a low volatility environment and a apparent change in the status quo in some metric, indicator, correlation, or Governmental policy, where a 2 standard deviation range expansion type move may be a reasonable target, I may take a shot, appropriately sized from a risk management standpoint, with a 1/42 chance of success based on static statistics. This type of trade will normally have a one day or intra week time stop associated with it. I would tend to go for very high positive gamma as would be seen with a Friday expiring option and thus would be subject to high theta decay, but a very favorable short term risk to reward ratio. My actual chance of success and potential for outsized returns may be much better than indicated by static statistics.
Another consideration is workflow efficiency and data visualization. I feel too much time is spent on looking for trading opportunities. Practice and a multiple monitor setup should go a long way to improve efficiency. For data visualization, I will set up a Black Scholes utilizing spreadsheet that will simultaneously compute and chart the metrics of interest under a range of time to expiration, moneyness, and volatility considerations for my various strategies. In addition, I will be able to more easily and effectively account for future term structure and skew assumptions in my trading decisions than what is currently offered on my trading platform.