Ultra-conservative, low maintenance ETF long options strategy

A

ahaskew

Hi Folks,

I've been observing and trading the options markets for a few years now and, let's say, have learned a few lessons. What strikes me is that, assuming you don't overtrade, it's the once or twice in a decade disasters that do the most portfolio damage for long strategies. This decade has actually had 3: high-tech bubble pop, 9/11, and of course GFC.

To reduce the losses, I've considered employing the following low-maintenance index option strategy:

Russell 2000 (RUT) currently trading at $562.77.
Buy a June 2010 $350 call option @ for $214 - there is almost no time premium associated with this purchase.
Deposit $350 in bonds or other debt instruments.

It's now the end of May 2010...
1) If the market has gone up you'll have a trading profit of $EndPrice minus $562.
2) If the market has tanked to 400, the call will be worth at least $2.50 (but almost certainly more as IV will increase). You can sell the call and roll down to another long call that has no time premium.
3) If the market has tanked to 350, the call will be worth about $19 (but almost certainly more as IV will increase). You can sell the call and roll down to another long call with no time premium.

With 2) and 3), on the way down you'll be significantly better off than a buy and hold investor because you won't have lost the entire difference between $562 and $EndPrice. But on the way back up again to $562 (and beyond) you'll keep all the profits.

Thoughts?
 
Keep in mind that buying a deep in-the-money RUT 350 call is no different from buying RUT and buying a 350 put. And you'll find that the put is much more liquid.

Using options, there are lots of ways to decrease your risk by giving up some upside potential. You've described one of them. But to truly gain a statistical edge you need to either identify a mispricing (one security out of whack compared to its normal relationship with another security, with the probability that the old relationship will re-establish itself), or find a way to foresee future price movements with better-than-random probability. What you've proposed does neither.
 
Quote from ahaskew:

Hi Folks,

I've been observing and trading the options markets for a few years now and, let's say, have learned a few lessons. What strikes me is that, assuming you don't overtrade, it's the once or twice in a decade disasters that do the most portfolio damage for long strategies. This decade has actually had 3: high-tech bubble pop, 9/11, and of course GFC.

To reduce the losses, I've considered employing the following low-maintenance index option strategy:

Russell 2000 (RUT) currently trading at $562.77.
Buy a June 2010 $350 call option @ for $214 - there is almost no time premium associated with this purchase.
Deposit $350 in bonds or other debt instruments.

It's now the end of May 2010...
1) If the market has gone up you'll have a trading profit of $EndPrice minus $562.
2) If the market has tanked to 400, the call will be worth at least $2.50 (but almost certainly more as IV will increase). You can sell the call and roll down to another long call that has no time premium.
3) If the market has tanked to 350, the call will be worth about $19 (but almost certainly more as IV will increase). You can sell the call and roll down to another long call with no time premium.

With 2) and 3), on the way down you'll be significantly better off than a buy and hold investor because you won't have lost the entire difference between $562 and $EndPrice. But on the way back up again to $562 (and beyond) you'll keep all the profits.

Thoughts?
More...


the potential edge derived from it will be lost on rolling costs, i.e. bid ask spreads on the contracts and commissions. this will become evident when you factor in the revenue stream which will you'll not be getting if holding the options rather than the underlying.

the odds of the price staying around the option strike price neighborhood are extremely thin, maybe around 10% or so. this means that the real advantage of capping the losses will not be realized more than, say, once per decade or so. hence, the potential advantage of such once-in-a-decade event has to be diluted across the rest of the years, resulting in a close to breakeven or relatively negative expectancy strategy when compared with the plain equivalent buy n hold strategy.
 
>> I've been observing and trading the options markets for a few years now and, let's say, have learned a few lessons. What strikes me is that, assuming you don't overtrade, it's the once or twice in a decade disasters that do the most portfolio damage for long strategies. This decade has actually had 3: high-tech bubble pop, 9/11, and of course GFC. <<

That's totally true but IMHO, you should be trading to gain via disasters rather than looking to lose a little less. At a minimum, hedging to conserve principal. Just curious, what does GFC stand for?


>> Buy a June 2010 $350 call option @ for $214 - there is almost no time premium associated with this purchase. Deposit $350 in bonds or other debt instruments. <<

It's now the end of May 2010...

1) If the market has gone up you'll have a trading profit of $EndPrice minus $562. <<

Small detail but it's end price less (strike + premium)


>> 2) If the market has tanked to 400, the call will be worth at least $2.50 (but almost certainly more as IV will increase). You can sell the call and roll down to another long call that has no time premium. <<

At 400 at end of May, 350 call should be worth a maybe $55. If the drop is slow and degrading, there's no guarantee that IV will be a lot higher. The loss will only be a few pts less than the long iindex holder ($159 vs $162)

If IV is double the current level, you might see 10-20 more pts of premium. It's still a nasty loss (down 140 pts instead of 162)


>> 3) If the market has tanked to 350, the call will be worth about $19 (but almost certainly more as IV will increase). You can sell the call and roll down to another long call with no time premium. With 2) and 3), on the way down you'll be significantly better off than a buy and hold investor because you won't have lost the entire difference between $562 and $EndPrice. <<

At $19 (RUT at 350), you've lost 195 pts whereas the index guy lost 212 pts. 195 is significantly better than 212? And now you're going to rol down to another no premium deep ITM call?

I think it's a very bad plan.
 
Thanks for your impressions dmo, crash n burn & spindr0.

In response...

dmo:
Buying RUT and a 350 put would cost $562 + $7 = $569. It would be cheaper to buy the 350 call and 350 put (which may have actually been what you meant). And I absolutely agree that if you can detect pricing anomalies and / or future price movements there are other far superior options strategies. The trouble is these require lots of research and strategy refinement, and a big time commitment.

crash n burn:
I tried to consider the rolling costs by trading infrequently (ie every 6 months). The 'quoted' bid / ask spread on deep ITM options is large, but is this the reality when you actually trade them? I recently bought a deep ITM RUT call and the execution price was almost exactly between the bid / ask.

spindr0:
Trading disasters is potentially lucrative for sure. This approach is really intended to be a buy and hold strategy for those (like me) that can't spend much time on analysis. It relies on the long term upward trend in the market continuing. GFC means 'global financial crisis'. Sorry, yes at 400 the call would be worth approx $55 - what I would have made clear (if my brain was working) is that there's still approx $5 of premium left meaning you'd be better off (slightly) than someone who has bought RUT outright.
 
Quote from ahaskew:

Trading disasters is potentially lucrative for sure. This approach is really intended to be a buy and hold strategy for those (like me) that can't spend much time on analysis. It relies on the long term upward trend in the market continuing. GFC means 'global financial crisis'. Sorry, yes at 400 the call would be worth approx $55 - what I would have made clear (if my brain was working) is that there's still approx $5 of premium left meaning you'd be better off (slightly) than someone who has bought RUT outright.
More...
I respectfully disagree. Trading intraday requires a lot of time and effort. Deciding whether to go to cash from buy and hold or flip over to short doesn't, particularly when you're talking about financial disasters that occur only a coupla times a decade.
 
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