What's the catch?

M

Mvic

I wonder if a strategy of selling progressively higher call strikes would work even in a rising market. For example, you sell a 1050 SP call when the underlying is (well) under 1050, then if it hits 1050 you buy a future and sell a 1060 strike, if it hits 1060 you buy a future and sell a 1070 strike and so on. If the market keeps rising, so much the better you are completely hedged and will collect the full premium on all your positions (also the deeper the option is in the money the less premium value it will have and thus will allow you to close out hedged positions that are deep in the money to free up margin for new naked out of the money calls). If the market drops you just cover your futures as they fall below the strikes. Spacing the strikes using say the weekly ATR or some factor of it (backtesting might help in determining the most profitable factor)will help avoid one getting chopped to bits.

Indeed, to increase profits one could sell out of the money puts too and sell the futures as they broke through the various strikes. Meanwhile the calls are doing very nicely, vice versa.

What is the main problem with this strategy? Obviously one has to a be very well capitalized and money management needs to be very disciplined. Does this strategy yield enough profit for it to be worth while (i.e. does it beat the SP)?
 
One problem is that by the time price hits 1050 you could be way under water due to premium rising as the price gets closer to strike. Of course this varies in terms of time till expiration etc, but premium on a near the money spx call could be exploding before you can adequately hedge.
 
as long as you held until expiration would it really matter(assuming one is sufficiently capitalized to employ this strategy)?

I guess part of what I am getting at is is the capitalization necessary for the success of this strategy so great that the ROI will end up being less than the SP's performace on an annual basis.

The trade off of selling a far out of the money call vs. only just out of the money call would be chop vs higher premium and lower potential draw down until expiration. The nice thing though about the draw down resulting from either increased perceivced volatility or an adverse move of the underlying, short of the strike, is that one can be sure that the draw down will disappear with time, unlike other draw downs in trading where there is no such certainty that allows us to comfortably suffer the draw down period and stay in a ultimately good trade.

 
I see which is why when I looked at this strategy decades ago I discarded it (pre globex). Now we have 24 hr trading the risk of getting caught in the gap is not as severe. Even when we get a fast market in the pit in the big contract buying or selling less than 50 ES doesn't involve too much slippage does it?

Another market where this strategy might work well is selling currency future options and hedging using the Forex market. Any thoughts?
 
I think you might still get chopped up if the price gets range bound near the strike of the option you sell. For example, if ES rolls between 1045 and 1055 for a few days (and you sold a 1050 call), how would you keep from losing your premium to the spread when you had to enter and cover several times? I think that this and sudden moves would be your greatest risks. Good luck.
 
You risk is clearly getting chopped to pieces. What would you do if it dropped under 1050? would you stop out? Where? What if it went back over? You could get stopped out every day for a few pts of loss and loose many times your earned premium. don't forget that the premium is so small that you write that if you stop out only a few times, you loose a few months worth of doing that.
 
He hit the nail on the head. Essentially what that strategy will ultimately come down to is you trading futures outright when the SP hits 1050. Say it goes to 1053 and you buy a future, 5 minutes later, its at 1045, what do you do ? Sell and take an 8 pt loss, hold and hope for a rally--in which case what do you do if it goes down to 1040 ? And although the SP does trade 24 hours a day, are you gonna be up all night watching them all the time ? If you were thinking of just using stops overnight, there may be more slippage than you think, or worse yet the market may move lower before you're able to get out of the position if you use a stop-limit. I would be very apprehensive about a strategy like this unless you have a definite opinion on which direction you think the market is going. Not trying to slam you at all, just wanted to make sure that you had some input on the worst case scenarion. Isn't there a phrase something along the lines of "A young trader thinks of how much money he can make on a trade, while an experienced trader thinks of how much he can lose."

Vega:D
 
Vega and Praetorian made great points. What they are relating is what happens in real time when you are trying to hedge this position. Basically you are taking a stand on what you believe the upside range extreme is when selling the call, but at the same time you are reacting with the hedge. So, to some extent you may have poor trading "location" on both the hedge and the initial option write of the OTM call. That's a stressful way to trade in general, and with all of the whip, mean reversion, failed breakouts, continuation breakouts, etc, etc of the underlying, you are not going to be in a very proactive state of mind if you are constantly hedging yourself after the fact...
 
this type of constructive criticism is exactly what I was looking for and why ET is so useful.

I trade the SP and currencies and am looking to incorporate an options strategy in to my trading to basically increase the probability of a profitable trade over a wider price range. Also to give me a bit of a cushion while riding out a move against a position but that is still within the parameters of the trade.

My basic hypothesis is that if I sell a straddle in a few derivatives that tend to move inversely while also trading the underlying derivative I can increase my profits, reduce the pain/stress of draw down, and increase the probability of having a profitable trade, and smooth out the old equity curve to a certain extent. That is the hypothesis at any rate. I am going to have to do a bit of work to see if it holds up or not.

Also finding some way of deciding which strike to sell either side is part of it.

Any comments appreciated, especially ones critical of this approach as they are the most helpful.
 
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