I study and monitor a particular index and would like to buy warrants based on the index. My system is as follows: Buy both call & put warrants with deltas around 50% for both. Put stop losses of ~5% loss on both calls and puts. If index goes up, I make on the calls and puts get stopped out. If index goes down, the reverse occurs. I am only at risk when the index does not move at all. But I will only enter a trade when the index's spot price is within a narrow range of available warrant strike prices: eg. index trading at 14200, I buy the available calls with strike of 14300 and available puts with strike of 14000. Since the range of the strikes is narrow, I expect either the calls or puts to become ITM before expiry. If this kind of setup is not available, I will not make a trade. Could anyone advise what are the potential downfalls and overlooked issues with this system? Thanx for your help and advice.
Historically, shorter term premium is priced higher than longer out premia. Since you're buying options you should consider buying the straddles out far enough (1 year) for the prices to develop sufficiently. I suggest you backtest your strategy but historical options data is not easy to come by. Potential windfall: Volatility is mean reverting. Buying the options at a spike in volatility probably puts the odds against you. I would backtest this strategy and include a variable for the strategy to goto cash if premium is historically overly expensive. If you wish to use it on major stock index you can use the VIX to derive an approximation of the historic premium prices. I have heard of strategies involving long dated straddles in currency options since they historically - over a long enough timeline - tend to trend sufficiently due to gradual interest rate changes (http://www.amazon.com/Inside-House-Money-Traders-Profiting/dp/0471794473). Good luck.
Thankyou makloda. So the only potential downfalls are a drop in the vega premium as well as loss due to theta as time approaches expiry. My current doubt is: suppose I get into a straddle, and index moves considerably in one direction. Either the calls or the puts will be stopped out. But for how long do I hold on to the profitable warrant? Should I wait for expiry, increase my position in those warrants, ...? Basically its very easy to enter the trade, I would like to know (using my method described in this thread) how to exit the trade profitably. Once again, thanx for your help.
By the way, i will be trading a major stock index like you pointed out above. Could you please tell me what is VIX, and how it helps to gather info on historic premium / volatility pricing?
C., the only way to find out is by backtesting. Guessing "I think it would be profitable" is a waste of your time and likely also money. You have to throw everything into a system and see how it would have performed under different market conditions. If it did well in the past only then you should consider deploying it with real money. The VIX is the CBOE volatility index. You can find information and downloadable historical data here http://www.cboe.com/micro/vix/historical.aspx "VIX measures market expectation of near term volatility conveyed by stock index option prices. The original VIX was constructed using the implied volatilities of eight different OEX option series so that, at any given time, it represented the implied volatility of a hypothetical at-the-money OEX option with exactly 30 days to expiration." The VIX measures the anticipated risk premium 30 days out. It would be interesting to compare this implied short-term volatility to implied longer term volatility (1 year out) and see how that could work into your idea.
Warrants? (g) What happens if the index moves enough to result in your stop loss being triggered on one side and then the index reverses and moves solidly in the other direction? Hint: 5% loss on both sides plus B/A slippage plus commissions What happens if the market gaps and the options never trade at the 5% loss level? Hint: 5% loss on one side and who knows how much add'l loss on the other (plus B/A slippage plus commissions)
When you know what the future will bring, you will always know what the best thing to do is. Otherwse, you place your bets and you use disciplined money management in order to protect profits and avoid big losses.
I dont plan on trading intraday, unless there is some huge movement or something. You reckon then that I loosen up my stop losses then? How does one base the stop loss - solely on total risk per trade?