Newbie question:
I can see OTM being cautious in the sense that the short strike is further away.
How is the closer ATM approach also cautious?
Vertical Spreads for Aggressive Growth
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Newbie question:
I can see OTM being cautious in the sense that the short strike is further away.
How is the closer ATM approach also cautious?
I'm going to try to be careful not to start another time wasting ATM/OTM debate here. If you want that, there is plenty on this thread and Optioncoach's thread:
http://www.elitetrader.com/vb/showthread.php?s=&threadid=49586
Here's my view;
FOTM credit spreads (selling cheap gamma) is inherently more risky. You are risking a much larger chunk of money to get a very small reward. Most times your risk:reward is something like 10:1 or worse. Now, the debate is that in terms of true risk you must consider probability of profit. This is exactly right! The probability for FOTM spreads is much higher, but is it proportionately higher? IMO that is a resounding no. The best expectancy is ATM and it just gets worse the further OTM you get.
So that theory leads to the idea of risk management. Sellers of cheap gamma lean heavily on the idea that they can avoid catastrophy by adjusting. The analogy of "picking up dimes in front of a steam roller" is very real. But you have to consider what is happening when you adjust/roll. You are simply closing out the initial position at a loss, and opening a new one. If the underlying moves against you quickly, you'll have a significant paper loss with FOTM. To roll, you are accepting that loss and relying on the idea that within a few of the following months you'll recoup the loss given the high prob trading style.
Now, ATM/CTM credit spreaders must also practice good risk management, but they need not avoid catastrophy. We don't ever have that much potential risk. The damage done by an adverse move is minor, and the ability to recoup losses on a roll compensate for the lower probability of profit.
Example:
Goal = 5% return on account this month on a $10K account.
FOTM:
sell 21 1380/1385 calls for $0.25
Max Risk = $9975
Max Reward = $525
Return = 5.25% (gross)
IOW, you have to risk pretty much your entire account to make your 5%.
CTM
sell 3 1345/1350 calls for $1.70
Max Risk = $990
Max Reward = $510
Return = 5.1% (gross)
IOW, less than 10% of your account is at risk during a big adverse move.
So if there is a big/fast move in the wrong direction, and theta doesn't have time to work, it is likely that you could be sitting on 50% (or larger) loss in your account. If you roll, you'll have to roll closer to the money, because you don't have any dry powder to pay the debit by rolling further OTM. If the roll worked, it would require almost 15 months of 5% gains to recoup the loss. Even if we say that theta worked a bit and you only took a 25% loss, it would still take 6 months to get back to B/E.
OTOH, the CTM position only results in about a 5-7% loss on account. It would take less than two months to recoup losses from even the biggest/fastest move, and you've got plenty of dry powder to roll further OTM if you want.
To be continued........
Now let's consider the other benefits of CTM credit spreads.
In the above example, I assumed a fill of 0.25 on the FOTM spread. I don't think you could've gotten that. That was being generous at todays prices. 0.20 is much more likely considering that the mid is 0.30 right now. OTOH I got filled at 1.70 on the 1345/1350 today. The mid right now is 1.75 (but in all fairness I think the mid was 1.80 when I got filled).
So for the FOTM you have to give up 0.10 of a 0.30 credit. You just gave up 33% of your return but still have the same amount of risk. Conversely, for the CTM you have to give up 0.10 of a 1.80 credit (5.5% of your return). Slippage for cheap gamma sellers is insane. So the only option in combatting the slippage is to widen the spread, in which case you have to either move a bit closer to the money, or accept a proportionately smaller credit (aka smaller return), but at least this way the risk might also decrease.
Also, you'll notice from the example in the above post, you have to trade 7X the number of contracts for FOTM (if spread width is equal).
Assuming a commiss of $1.25/contract and no flat fee. The FOTM seller lost 10% of the return to commissions. The CTM seller only lost 1.5% of return to the broker.
So, that is why I trade ATM/CTM. Then there is the fact that I trade OPM. How many clients will I lose if an FOTM position goes wrong and I have a 50% drawdown? 5% drawdown is mild in comparison, and my partners don't sweat that at all.
Like I said, I'm not looking for a debate. Just clarifying a previous statement for a newbie.
next episode came quick huh!?
LOL, just realized that the post was getting long so I decided to split it up a bit.
One more thing for the newbie...
In regards to selling FOTM, think about it this way. It is very similar to selling naked premium. If you think selling naked premium is too risky, then you might re-evaluate any decision to sell FOTM spreads.
In regards to selling FOTM, think about it this way. It is very similar to selling naked premium. If you think selling naked premium is too risky, then you might re-evaluate any decision to sell FOTM spreads.
Excellent explanation on CTM spreads! I like the idea as well when I can find overbought resistance or oversold support.
I do not think it is a question of what is the better strategy but what is the better strategy for the individual. I am not a fan of covered calls but I bet many people do real well with it.
That is why I never debate strategies because it is pointless. Every strategy has pros and cons and the strategy is meaningless. How the individual manages the position and risk is all that matters.
For example, I could never do the no touch exotics risk arb does and find them too risky for me, but he does quite well with them, even when he has to eat some big losses lol...
I do not think it is a question of what is the better strategy but what is the better strategy for the individual. I am not a fan of covered calls but I bet many people do real well with it.
That is why I never debate strategies because it is pointless. Every strategy has pros and cons and the strategy is meaningless. How the individual manages the position and risk is all that matters.
For example, I could never do the no touch exotics risk arb does and find them too risky for me, but he does quite well with them, even when he has to eat some big losses lol...
Completely agree. Just explaining why I trade the way I do. For the sake of full disclosure, I should list the things that I don't like about selling CTM.
1) It isn't "set it and forget it". This makes for some exciting trading, but you must be much more involved. I work a "real job" too and sometimes the two conflict.
2) Repeated drawdowns for some people can lead to a loss of confidence and inability to pull the trigger. You must be a calm person with the ability to think rationally and accept more frequent losses.
3) Sometimes you have to leave some profit on the table because it simply makes sense to offset the position in order to avoid a reversal or free up margin. The FOTM spread is pretty much worthless in those cases, while the CTM, if we are at all close to the underlying (even on expiration day), still has a fairly significant value attached to it.
Hey, I'm trying to do my part to increase the liquidity. The more people trading SPX options, the bigger my fund can get.
P.S. I'm not going to another of mo's seminars. He ran out of promo t-shirts and I'm offended that I didn't get one.