Systematic Options Writing

I was looking at the results for funds that write OTM index options the other day. They are having the slowest year yet I think. I noticed that Ansbacher hasn't posted his April results yet.

:confused:
 
if i knew of no other profitable system for trading, i'd employ a premo-collecting based strategy, and i'd probably make money every year.

the strategy is not really that hard if you find the right index to play with. avoid the juicy high iv's that swing. if you're doing this for some nutty biotech stock or google, you'll probably blow out sooner than later. but there are many things out there that are pretty stable and have been stable for well over a decade(s). if you can't find any, look outside the u.s. or perhaps even stocks if you have to.

and contrary to what people here assume, or at least it was the impression that i got, you don't sit and fold your arms as if it were a fixed butterfly or condor.

you have to play defense and counter-attack some moves, and that's how you make your money. it's all mechanical though, so in a way, it doesn't really require that much guess work. only takes some patience and discipline to react.
 
It is true that the values given for premiums in this strategy are a bit unrealistic and like I said, I didn’t write this but why do you say it is theoretically wrong? I have written my own real world example of a trade I’m in right now. Initially I wrote it as instructions but I have changed it to reflect my experience.

My intention was originally to provoke a discussion on the general subject of systematic writing strategies and hear what others had though of. I realize that the example given may not have been the best…however, I tend to think that since this kind of trading is a dynamic rather than static methodology, it has the potential to outperform a buy and hold action. I use the term “buy and hold” in a general sense to describe the action of setting up a spread or any position, then holding it without alteration until expiration. I would even classify having a stop loss or a profit target as systematic even though these are basic concepts employed by many people. Pyramiding is also quite common. Again, the idea here is that implementation of a predetermined hierarchy of action in a reactive way is a superior way to invest, even if the ideas are basic in nature. Anseld said it brilliantly…

you have to play defense and counter-attack some moves, and that's how you make your money. it's all mechanical though, so in a way, it doesn't really require that much guess work. only takes some patience and discipline to react.
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Thank you for all of your posts so far, I hope this thread will continue!
 
Systematic Options Writing

Example: DIA

For this example the DJIA ETF Diamonds Trust Series will be used (DIA) for illustrative purposes. This example is done in a worst case scenario purposefully to demonstrate the versatility of this strategy. This can be a bullish or bearish strategy depending on which side is initially taken but here we will assume the bullish view and see what happened when I was wrong.

The beginning date was March 4, 2005 when the DIA closed @ 109.5, so I was bullish and bought 100 shares at the end of the day at that price. Historically this was an all time high for the DIA. To hedge this position I purchased a protective put in this case, the May 109 put for 1.95. This brings my cost basis to 111.45 (109.5 + 1.95) but provides infinite downside protection.

From here the stock declined 5% over the next 3 weeks and on March 29, closed @ 104. My loss at his point would have been 5.5 points had the put not been purchased but because it was, I had lost only -2.25 points because the put is now worth 5.2 (5.2 – 1.95 = 3.25 – 5.5 = -2.25). In other words, the put has appreciated 3.25 points in value which partially offsets the 5.5 point loss in the stock. I was still bullish at this point and believed the stock would recover. To further cover the loss, I sold the ATM, May 104 put for 1.95 bringing my cost basis to .30¢. From this point on, if the DIA went up, I would simply hold my current position and as the stock approaches my buy price of 109.5; the price of the 104 put that was sold will drop to zero, and I would be able to buy it back for full profit. If that were to happen I would essentially own the 109 protective put for free (well not quite for free, actually .30¢ but for arguments sake….it’s damn cheap). This means that if the stock were to drop again, no further protective action would need to be taken because any loss in stock would be exactly offset by the 109 which was paid for by the sale and repurchase of the 104 put; time value and theta decay were also taken care of by the 104 sold put. If the DIA goes up, great, I can afford to let my profits ride and may at some point put on a collar if I begin to feel bearish in the future.

In actuality however, the stock traded sideways for about a week and a half then took a nosedive all the way down to 100. Now I can do several things here and it’s a good bet that the stock will recover at least a few points after such a drastic decline, but for arguments sake, let’s say I’m still not sure and expect that the stock may decline further. I now sell a covered straddle and cover the 104 put that I sold. When the straddle was sold, it was also time to sell the original 109 put because if the stock rises, a loss will accrue the further it strays upward from the 100 call. This is because I would be obligated to deliver the shares at this price. So the profit on the put must be taken in order to lock in the price of assignment. At this point I should examine the situation because things have gotten a bit complicated. I have lost 9.5 points in the stock but gained 7.85 in the 109 put bringing the loss to 1.65. But then the 104 put was sold and covered for a loss of 2.15 points. My total loss at this point would be 3.8 points. But I just sold the covered straddle for 3.6 which brings my total loss to just .20¢ if the straddle is held to expiration. Also important to note is that when a straddle is sold, you are essentially short vega in the sense that a decrease in vega will benefit you because it will cause the IV of both straddle options to drop, diminishing the value of the spread. Today is May 16, and the DIA closed @ 102.64 with 4 days left to expiration. If the DIA drops below 100 I will have to purchase another 100 shares at this price and will sell 2 covered calls on the position. Whatever happens, my original cost basis for the 100 shares I currently own will be 100.20, so I could close out this position right after expiry if it is below 100. If it closes above 100, I will be assigned on the straddle call and my total loss will be just .20¢, not bad for a 10 point drop in the stock.
 
If you are going to write spreads then the best way to do it is on the SPX, OEX or XEO. Given the volatility skews in the indexes and the ability to use options on futures as well, there are more opportunites to collect premium than dealing with the individual risks of a specific stock. It takes strict risk management to do this but given the cushion of deep OTM strikes and the ability to partial hedge using SPY and OEF and the same options on futures, it is possible to collect nickles and dimes regulalry even sustaining a few losses.

The key is to avoid going for the home run and keep strict risk management. Take advantage of the put skews on indexes, use 40 days or less to expiration and stick with spreads as far OTM as possible.

It is by no means easy. But with the right trading plan you certainly can make good money.

Phil
 
For a systematic writing plan, I've been looking at the SPX because I like the idea of European exercise and cash settle, but I've heard that this index is a killer for the routine retail trader because of the bid-ask. Is this true in practice? If so, what other index with European-style exercise would be better? I wouldn't mind trading options on the SPY or the Q's, but I don't want the worry about early assignment. I plan on trading ratio call and put spreads and verticals.
 
Yellow:

I write spreads monthly on the SPX and XEO/OEX. The bid/ask spreads are wide but you can usually split them most of the time or shave to one side of the middle but you never have to pay the actual bid and ask shown. I was told that since the SPX is the only game in town for the S&P 500 (will get to SPY in a second), the market makers keep the spreads wide so they can take different orders at different prices and make a good spread. I also heard that there are a lot of MMs trading the SPX so if you split the bid/ask you will have a good chance of getting filled as there is competition to take the order flow.

So I have not been killed by the wide b/a spreads but it does make it a little harder to get in and out. However given the movements in the SPX I rarely need to get in and out in a matter of seconds. I usually get fills in a few minutes and here is what I do. I first place the order at the halfway point for the spread to sell. After a few minutes, I shave $0.05 at a time and wait. Usually if I cannot get the midpoint, I can get $0.05 to $0.15 off the center which is not bad given the sometimes $1.00 wide b/a in the SPREAD orders.

The further OTM and closer to expiration, the harder it is to split b/a spreads to open new positions. But looking at JUNE now and 1090 and near strikes, you can come close to the middle of the b/a spreads or just off center.

SPY is 1/10 of the SPX and has less premiums OTM to be able to sell. SPY is better for long positions on the S&P and the SPX is better for short spreads.

Phil
 
I heard order size is also a big factor in getting fills. Maybe less pertinant for the SPX but as it relates to other futures options I believe it's important. Could you confirm this? Do you have an easier time getting fills for, say, 10 contracts than you would for 1 or 2?
 
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