Saturday, March 3, 2012
Thanks for the kind words.
It is true. As a trader we MUST do a written plan if we are to be successful, because a written plan will give us the method of success and perhaps the discipline to follow it. Most traders are in trading so they can change their life. To put it on a one for one basis, you will never change your life until you change something you do daily. That, of course, applies all across life as well.
Doing that written trading plan is a start.
FROM THE LOG: Monday, March 5, 2012
No Transactions today
AIN”T THOSE GREEKS GONE HOME YET?
Like the Greek National situation wherein the credit default and national bankruptcy is being spun, or characterized, as a simple bailout, our Greeks won’t go home and leave us alone either.
If we are to trade options effectively there are a few things we need to know about. One is volatility and the others are the Greeks. Last week we wrote about Delta and we learned that if you give the market a chance to take money away from you through Delta…it will!
Today, we will cover three more Greeks, Theta, Vega and Gamma. Rather than list their very technical definitions, let’s make it simple.
We sell credit spreads. Delta measures the relationship between the price of the underlying and the price of the option. Theta measures the time decay of an option’s premium. Vega measures the options sensitivity to VOLATILITY. Gamma measures how fast DELTA changes in the underlying.
There you have it. In four sentences, you have five important properties of options needed to find setups and make money.
Again, we SELL options as credit spreads, or expressed differently, we collect premium, or even another way, we SELL volatility (V). That makes us, among other things, a V-Trader.
Let’s simplify even further. High Implied Volatility (IV) compared to Statistical Volatility (SV) is good. High Delta (HD) is good. High Theta (HT) is good. High Vega (HV) is good. Low Gamma (LG) is good. Making money (MM) is good. Everything is good…Let’s not get carried away.
Taking the High Road…
Volatility Based Trading (VBT). Options are like a 3D chess game. The three dimensions are the price of the underlying, time and volatility. The most misunderstood dimension is volatility. To have success in trading options we must understand the current volatility situation and focus on volatility while neutralizing other factors. We do that by selling options when they are expensive and occasionally buying options when they are cheap. Without getting into the complications of describing technical volatility, we can say that High Volatility (HIV) is equivalent to expensive options and Low Volatility (LIV) is equivalent to cheap options. So when options become way too expensive (or too cheap) the V-trader has a huge edge.
When the options of a particular asset are more expensive than usual, that additional expense may be justified by unusually high volatility in the underlying. When the extra IV is high compared to the SV, it is advantageous to SELL options, or to be SHORT VOLATILITY. The volatility principle (VOP) is called “the mean reversion tendency of volatility” (MERTOV) All that means is that eventually, the volatility will revert to the mean and come down, draining all that juicy premium right into our trading accounts.
The purest selling strategy is the naked strangle, which involves selling out-of-the-money (OOM) Calls and Puts. Way out-of-the-money (WOOM) puts and calls provide greater protection from having our strike price being overrun (SPBO) by the underlying and increases the probability of making money, but we collect correspondingly less premium.
Sometimes, we buy an option a few points beyond our short option to increase the protection, limit liability, and create a credit spread, such as Iron Condors or Bear Call Spreads, but this considerably weakens the positions Vega (which measures the option’s sensitivity to Volatility). The reason we want a substantial Vega is so when the IV comes down our position makes money.
We use OOM and WOOM options to give the underlying some room to wander around and not touch our strike prices. The further out of the money we go, the lower our returns but the greater the probability of achieving those returns. Options with Higher Vega (HV) will respond best when the IV comes down. The longer term options have the additional advantage of having Lower Gamma (LG). Gamma measures how fast DELTA changes with price changes in the underlying. Options with LG take a bigger price change in the underlying to imbalance our position.
That means fewer adjustments. Fewer adjustments, or defensive moves, means less money to the broke-er and more money to the good guys…us.
Tomorrow, we will talk about Volatility Skew, Covered Calls and the Low Road.
CRUDE OIL, GOLD
FROM THE LOG: Tuesday, March 6, 2012
+3 MAY 96 Puts @ 1.25
We adjusted our short puts as the Delta of the position went beyond our pre-set limits which resulted in a small loss. This is all part of keeping losses small and letting gains run. These “gains” were not running.
+3 APR 1610 Puts @ 9.00
We adjusted this position because the Delta of the position went beyond our limits. We did not have the order on automatic and the loss was slightly greater than it needed to be. We will do no future futures positions unless we set up automatic orders.
Tomorrow, we will likely reset the positions using WOOM options. Whenever we close a position with a loss, which is a defensive adjustment, we reset the spread and always sell more premium on WOOM options than it costs us to close out the losing position. That in effect, makes it very difficult to catch us with a permanent loss, but that does have the effect of stretching out our earned income period.
We are now flat the futures options markets. That means our pipeline is empty of premium. When that occurs, there is no premium to convert into earned income and we are not achieving our goal of consistent income because there is NO income…consistent or inconsistent.
Our goal in our Futures Pilot Portfolio, which we started late last year at $65,000, and is now at $100,000, is to have premium of $20,000 in the pipe and cooking at all times, yielding a minimum of $10 K a month. The amount of Premium that we are able to capture is based on the size of the pilot portfolio, or the capital available, AND Volatility. The capital provides the margin and the volatility provides the premium that we convert into earned income. Or, more correctly, it is premium that Sister Theta and her band of merry daily decay artists (BOMDDA) convert into earned income for us.
So why don’t we have the pipeline filled up? Volatility of late has been relatively low, or reverted to the mean, meaning that the Implied Volatility (IV) is too close to the Statistical Volatility (SV), leaving fewer opportunities to create High Vol positions. Crude has had increasing IV for the last few days so there is some promise there, although we must be careful of the Geopolitical considerations because the Middle East is a powder keg right now and way too many people have matches.
One other strategy for selling options, which is a different kind of animal than we have been discussing, is covered writing, or covered calls. This is where we buy the stock, or future, and sell an out of the money call, forming a “covered” transaction. While we use this strategy in our Dividend Portfolio, our main objection to this form of trading is that it is not Delta neutral. Never-the-less, we must pay attention to Volatility levels when setting up covered call trades.
Thanks for the reply and I am glad you find the Journal interesting.
By automatic orders I am referring to Automatic Contingent Orders to close our short options or credit spread once we have one in place. A number of the options brokers allow these.
Whenever we create a plan for a trade we establish our exit conditions. Most traders think of an exit based on an option price that limits any losses on the trade. That is okay, but it is very imprecise and requires too much work … besides with options there is a problem. We cannot set an option exit price as a stop loss order and unwinding a spread is then dependent on how vigilant a trader is in watching the monitor, in a completely manual order process. The truth is though, vigilance does not work out very well, as I have proven on more than one occasion. Fortunately, there is a better way.
An order pegged to the underlying price or other option attribute. We primarily use DELTA to enter and exit trades, so we simply set up a contingent order based on Delta. That applies going into the trade and out of the trade, thereby automating the process. For example: if the underlying goes against us, when it reaches a predetermined Delta our contingent order is executed and we are automatically out of the trade with minimal loss. That Delta point varies somewhat depending on where we entered the trade, the type of underlying, etc, but generally is in the area of 12% to 20%.
By putting our trades on auto pilot, so to speak, we eliminate much of the slop in the process and are able to tighten down our profits and our losses, yielding substantially better net results.
I will write more on orders as we go.